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THE  LIBRARY 

OF 

THE  UNIVERSITY 

OF  CALIFORNIA 

HENRY  RAND  HATFIELD 
MEMORIAL  COLLECTION 

PRESENTED  BY 

FRIENDS  IN  THE  ACCOUNTING 

PROFESSION 


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U-^SL 


N 


BNRVR.  HATFIELD 

<  Gv^  l.?^  C0^4TE  AVENUE 
BERKELEY     CALIFORNIA 


Digitized  by  the  Internet  Archive 

in  2007  with  funding  from 

IVIicrosoft  Corporation 


http://www.archive.org/details/bookkeepingaccouOOcolerich 


INTERNATIONAL  BUSINESS  LIBRARY 


BOOKKEEPING 
ACCOUNTING 

AND 

AUDITING 


BY 


WILLIAM  MORSE  COLE,  A.  M. 

Assistant  Professor  of  Accounting  in  the 
Harvard  University. 

Graduate  School  of  Business  Administratioa. 


NATIONAL  INSTITUTE  OF  BUSINESS 

RACINE      -      CHICAGO 


COPYRIGHT  1914  BY 
INTERNATIONAL  LAW  &  BUSINESS  INSTITUTE 


WHITMAN  PUBLISHING  CO. 
RACINE    -    CHICAGO 


"Ever  judge  of  men  by  their  professions.  For 
though  the  bright  moment  of  promising  is  but  a  mo- 
ment, and  cannot  be  prolonged,  yet  if  sincere  in  its 
moment's  extravagant  goodness,  why,  trust  it,  and 
know  the  man  by  it,  not  by  his  performance." — 
Browning, 


"A  lawyer  without  history  or  literature  is  a  mechanic, 
a  mere  working  mason ;  if  he  possesses  some  knowledge 
of  these  he  may  venture  to  call  himself  an  architect." 
^Sir  Walter  Scott. 


ivi511300 


PREFACE 

One  thing  which  distinguishes  bookkeeping  and 
accounting  from  most  other  lines  of  human  activity 
is  that  they  deal  with  figures  which  are  more  or  less 
abstract.  One  does  not  handle  in  bookkeeping  and 
accounting  definite  things  which  can  be  coimted, 
looked  at,  examined,  and  held  in  the  mind's  eye 
while  one  is  thinking  about  them.  One's  thinking 
must  be  done  through  the  imagination.  One  must 
reason  and  draw  conclusions  about  things  which, 
though  real,  can  be  grasped  only  by  the  brain;  for 
the  accountant  cannot  cut  up  every  article  of  mer- 
chandise and  every  note  into  a  portion  which  is 
investment  and  another  portion  which  is  profit.  This^ 
involves  at  first  a  certain  amount  of  hard  thinking, 
but  by  long  practice  one  may  become  so  familiar  with 
f imdamental  principles  that  for  common  transactions 
one  reaches  right  conclusions  unconsciously,  from 
force  of  habit.  So  one  escapes  the  confusion  of  try- 
ing to  think  about  several  sets  of  abstract  things  at 
once.  That  is  to  say,  if  the  figures  themselves  are 
abstract  and  require  on  the  accountant's  part  some 
effort  to  hold  them  firmly  in  his  mind,  he  ought  not 
to  be  trying  at  the  same  time  to  reason  out  the 
method  which  he  shall  use  in  making  an  entry;  for 
he  may  find  the  effort  to  do  two  lines  of  thinking  at 

3 


4  PREFACE 

once  so  confusing  as  to  lead  to  wrong  results.  The 
principles  of  bookkeeping  and  of  accounting,  there- 
fore, should  be  so  thoroughly  familiar  that  they  are, 
for  most  transactions,  matters  of  second  nature. 

Everyone  who  is  not  an  expert  pianist  wonders 
how  a  skilled  performer  can  work  his  fingers  with 
such  rapidity  and  hit  the  right  notes  with  just  the 
right  force,  hold  them  for  just  the  right  time,  and 
at  the  same  time  work  the  pedals  so  that  no  note 
shall  be  sustained  beyond  its  due  season.  It  appears 
as  if  the  pianist  were  reading  the  signature  to  indi- 
cate sharps  or  flats,  the  notes  to  indicate  what  keys 
should  be  pressed,  the  value  of  the  notes  to  indicate 
the  duration,  the  marks  of  expression,  the  keys  under 
his  fingers,  and  the  pedals  under  his  feet,  all  at  the 
same  time.  This  looks  like  superhuman  power.  As  a 
matter  of  fact,  of  course,  the  experienced  performer 
is  perfectly  unconscious,  after  he  has  begun  to  play, 
of  the  signature — ^because  once  in  the  swing  of  the 
key  he  unconsciously  introduces  the  proper  sharps  or 
flats  because  of  long  practice — ^lie  unconsciously  holds 
the  notes  the  right  length  of  time — because  from  long 
practice  the  sight  of  a  certain  type  of  note  produces 
almost  automatically  in  his  fingers  the  right  length 
of  pressure  upon  the  key, — and  without  his  con- 
sciousness of  it  the  sight  of  the  pedal-mark  on  the 
page  depresses  his  feet,  or  the  ring  of  the  notes  in  his 
ear  results  in  an  automatic  pressure  of  the  pedal. 
The  player,  in  other  words,  though  he  appears  to  be 
doing  many  things  at  once,  involving  the  sight  of 
many  things  at  once,  is  doing  most  of  his  work  almost 
unconsciously,  and  is  governed  almost  entirely  hr 
the  sensation  produced  in  his  ear  by  the  automatic 


PREFACE  5 

connection  between  the  printed  notes  and  his  fingers 
and  feet.  The  same  thing  is  true  of  any  practical 
work.  Only  after  we  have  had  much  experience 
in  any  line  of  work  can  we  do  difficult  things 
easily,  but  those  things  which  to  a  novice  seem 
beyond  comprehension  are  matters  of  commonplace 
after  the  wonders  of  reflex  action  have  had  oppor- 
tunity to  work. 

The  singular  thing  about  reflex  action  is  that 
instead  of  waiting  for  the  nerves  to  carry  a  message 
to  the  brain,  and  then  the  brain  to  send  another  mes- 
sage back  to  a  muscle  telling  it  to  move,  a  short  cut 
has  been  made  directlv  from  a  nerve  to  a  muscle, 
which  causes  the  muscle  to  act  even  before  the  brain 
knows  what  is  going  on.  If,  for  instance,  I  move  my 
hand  unconsciously  against  a  thistle,  before  I  am 
really  aware  of  the  fact  that  I  am  in  pain  my  hand 
has  involuntarily  shrunk  away  from  the  sharp  point. 
I  become  aware  of  the  pain  practically  at  the  same 
moment,  or  even  after  the  withdrawal  of  the  hand, 
because  the  nerve  which  felt  the  pain  sends  a  message 
directly  to  the  muscle  and  causes  the  hand  to  be 
withdrawn  at  the  same  time  that  it  sends  the  message 
to  the  brain  notifying  it  of  the  discomfort.  This  is 
the  secret,  as  has  been  suggested,  of  all  skill,  and  the 
bookkeeper  is  not  competent  to  do  rapid  work — or, 
we  may  almost  say,  even  accurate  work — unless  the 
principles  to  govern  his  operations  are  so  far  a  part 
of  his  mental  equipment  that  without  stopping  to 
think  how  the  thing  ought  to  be  done  he  does  it  in 
the  correct  way.  The  first  step  for  anyone  wishing 
to  learn  to  be  an  accountant  is,  therefore,  to  master 
thoroughly  the  fundamental  principles — ^to  master 


6  PEEFACE 

them  so  thoroughly  that  he  never  has  to  stop  to  think 
what  should  be  debited  or  what  credited  in  any  trans- 
actions but  those  which  are  of  an  unusual  nature. 

This  book  is  intended  to  discuss  all  the  common 
principles  of  accounting  as  found  in  normal  business, 
and  to  make  them  clear  to  persons  who  wish  to  study 
them  without  a  teacher.  The  best  teacher  is  not  so 
much  the  one  who  teaches  as  the  one  who  gives  his 
pupils  opportunity  and  guidance  in  learning.  The 
learning  must  be  done  by  the  pupil  himself.  This 
book  professes  only  to  give  the  opportunity  and  the 
guidance.  It  is  undesirable  in  a  book  of  this  tyipe  to 
afford  a  large  amount  of  practice  in  bookkeeping  or 
accounting  work,  for  if  that  were  done  the  pages 
would  be  filled  with  repetitions  of  similar  transac- 
tions which,  though  necessary  for  the  beginner, 
would  deprive  him  of  the  opportunity  to  do  his  own 
thinking.  The  common  transactions  of  business  are 
so  well  understood  by  everyone  above  childhood  that 
practice  can  usually  be  provided  by  each  student  for 
himself  through  a  very  simple  exercise  of  the  imag- 
ination. For  instance,  one  needs  to  know  automatic- 
ally that  a  sale  of  merchandise  for  cash  involves  a 
debit  to  Cash  and  a  credit  to  Merchandise;  and  the 
student  should  have  come  across  that  transaction  and 
made  the  proper  entry  so  many  times  that  instinct- 
ively the  sight  of  the  words  *^sold  for  cash"  brings 
up  to  his  mind  the  words  ^  ^  Cash  to  Merchandise. ' '  It 
is  recommended,  therefore,  that  anyone  undertaking 
to  use  this  book  as  a  means  of  learning  the  arts  of 
bookkeeping  and  accounting  construct  for  himself  a 
large  number  of  imaginary  transactions  involving, 
over  and  over^  all  the  common  transactions.    This 


PKEFACE  7 

should  not  be  done,  however,  by  outlining  a  large 
number  of  transactions  of  the  same  sort  following 
one  another  in  immediate  succession.  If  one  writes 
one  hundred  transactions  of  the  same  sort  one  after 
another  one  is  not  cultivating  the  habit  of  think- 
ing about  them;  indeed,  one  is  doing  nothing  more 
than  training  the  hand  to  make  entries  in  the  right 
form;  for  after  the  first  entry,  with  a  knowledge  that 
the  transactions  are  the  same,  the  brain  is  not  called 
into  play.  The  proper  method,  then,  of  inventing 
transactions  for  practice  is  to  alternate  them  so  that 
very  seldom  do  two  of  the  same  sort  come  together. 
If  a  sale  for  cash  is  foUow^ed  by  the  issue  of  a  note 
in  payment  of  a  bill,  and  that  by  the  payment  of 
wages,  and  that  by  the  borrowing  of  money,  or  the 
payment  of  a  bill  in  cash,  or  the  receipt  of  interest 
money,  etc.,  so  that  the  mind  is  obliged  to  jump 
around  from  one  sort  of  thing  to  another  with  great 
rapidity,  and  all  these  transactions  come  again  and 
again  and  again,  the  mind  soon  acquires  the  ability 
to  make  the  entries  by  the  kind  of  reflex  action 
already  referred  to.  When  one  has  acquired  facility 
in  making  these  common  entries  one  should  attempt 
to  make  entries  of  a  peculiar  type,  beginning  with 
those  that  are  merely  unusual,  though  simple,  and 
then  gradually  increasing  complexity  until  one  has 
mastered  the  ready  handling  of  practically  all  cases 
that  may  arise.  In  the  appendix  will  be  found  a 
number  of  such  rather  complex  cases  to  illustrate 
the  sort  of  practice  necessary. 

In  the  first  part  of  the  following  pages  will  be 
found  not  only  a  careful  working-out  of  the  common 
transactions  of  business,  each  repeated  in  one  form 


8  PEEFACE 

or  another  several  times,  but  an  indication,  by 
typical  illustrations,  of  the  bookkeeping  for  less  fre- 
quent transactions.  Anyone  who  has  absolutely 
mastered  the  principles  here  expounded — that  is, 
has  mastered  them  so  thoroughly  that  he  is  not  likely 
to  stumble  in  their  application — ^is  competent  to 
make  the  entry  for  any  transaction  that  he  under- 
stands. 

Accounting  principles  require  somewhat  the  same 
sort  of  practice  as  that  suggested  in  connection  with 
bookkeeping,  though  to  construct  for  it  situations 
out  of  pure  imagination  is  not  quite  so  easy.  The 
reader  who  wishes  to  master  accounting  is  recom- 
mended to  invent  for  himself  situations  involving 
the  principles  expounded  in  the  latter  part  of  this 
book — such  as  the  distinction  between  capital  and 
revenue,  between  one  class  of  expenses  and  another, 
between  stable  values  and  depreciating  values,  be- 
tween values  involving  only  capital  and  those  involv- 
ing interest  and  discount.  Then  such  transactions 
may  be  made  more  complicated  by  the  introduction 
of  two  or  three  of  these  distinctions  at  the  same  time, 
and  so  on  until  a  high  degree  of  complication  has 
been  handled  successfully.  Students  of  accounting 
commonly  have  the  expei^ence  of  thinking  they 
understand  what  in  reality  they  do  not  understand. 
Often  they  understand  just  what  they  see  before 
them  as  a  problem  but  fail  to  see  just  how  big 
the  problem  is.  Every  principle  should  be  worked 
out  in  detail,  in  Hack  and  white,  and  the  student 
should  accustom  himself  to  thinking  exactly  how 
every  situation  would  look  upon  the  books.  If  all 
situations  desirable  to  study  were  presented  in  type 


PEEFACE  9 

in  this  text-book,  the  student  would  be  deprived  of 
the  valuable  practice  of  working  them  out  for  him- 
self, and  would  become  better  accustomed  to  seeing 
them  in  type  than  to  seeing  them  in  his  mind's  eye. 
He  should,  therefore,  in  thinking  of  situations  de- 
scribed in  this  book,  try  to  see  how  each  would  look 
in  books  of  account,  and  then  he  should  write  the  en- 
tries for  himself.  As  he  reads  the  text,  he  may  then 
see  whether  the  facts  there  mentioned  apply  to  the 
situation  that  he  has  put  before  himself.  If  not,  he 
should  go  back  and  see  what  is  the  discrepancy  be- 
tween the  situation  he  has  recorded  and  that  de- 
scribed. Then  he  is  in  a  position  to  try  the  conclu- 
sions suggested  in  the  book  with  the  actual  figures 
before  him.  This  method  fixes  in  his  mind  the 
appearance  on  the  books  of  all  common  situations 
and  enables  him  in  practice  to  recognize  at  once  the 
things  which  he  has  here  been  studying  theoretically. 
This  should  be  done  particularly  for  things  that  are 
here  discussed  but  not  worked  out  in  detail  in  the 
printed  form. 

For  the  interpretation  of  accounts  the  best  prac- 
tice is  to  get  hold  of  the  reports  of  corporations  and 
partnerships,  though  the  latter  are  seldom  published, 
and  attempt  to  read  between  the  lines — to  see,  for 
instance,  why  each  particular  kind  of  asset  was  in- 
creased or  decreased  from  one  year  to  another,  from 
what  source  the  assets  were  increased  and  the  liabili- 
ties decreased,  or  how  it  happened  that  the  assets 
were  decreased  or  the  liabilities  increased.  Wherever 
statistics  can  be  obtained  to  show  the  detailed  opera- 
tions of  any  company,  as  is  always  possible  with 
railroads,  the  attempt  should  be  made  to  relate  those 


10  PEEFAOE 

operations  to  the  income  sheet  and  to  the  balance 
sheet  so  that  one  may  see  how  far  the  various  parts 
of  a  report  are  consistent  and  what  light  each  part 
throws  upon  the  others. 


CONTENTS 


CHAPTEE  I.  INTRODUCTION  13 

CHAPTER  II.  DEBIT  AND  CREDIT 19 

CHAPTER  III.  THE  METHOD  OF  ENTRY 33 

CHAPTER  IV.  THE  COMMON  LEDGER  ACCOUNTS.  49 

CHAPTER  V.  THE  PRACTICAL  OPERATIONS  OF 

BOOKKEEPING  109 

CHAPTER  VI.  DRAWING  CONCLUSIONS  FROM  THE 

BOOKS 139 

CHAPTER  VII     SOME  HIGHLY  DEVELOPED  TYPES 

OF  BOOKKEEPING 175 

CHAPTER  VIII.     THE  PECULIARITIES   OF  CORPO- 
RATION ACCOUNTS 213 

CHAPTER  IX.    PROPERTY  OR  EXPENSE  ? 239 

CHAPTER  X.     DEPRECIATION ' 263 

CHAPTER  XL     PROFITS 281 

CHAPTER  XIL     THE  INCOME  SHEET 305 

CHAPTER  XIII.     THE  BALANCE  SHEET 315 

CHAPTER  XIV.     THE   INTERPRETATION   OF   BAL- 
ANCE SHEETS 331 

XI 


12  CONTENTS 

CHAPTER  XV.     THE  DETEEMINATION  OF  COSTS. .  347 

CHAPTER  XVI.  SETTLEMENTS  BASED  ON  AC- 
COUNTS—PARTNERSHIPS, IN- 
SOLVENCY, TRUSTEESHIPS. ...  375 

CHAPTER  XVIL     AUDITING 397 

APPENDIX 451 

INDEX   475 


ACCOUNTING  AND  AUDITING 


CHAPTEE  I 

INTEODUCTION 

The  art  of  accounting  is  commonly  thought  to 
include  only  making  a  record  of  facts.  It  chances 
that  as  industry  has  developed  in  recent  years  the 
making  of  the  record  is  the  least  important  part  of 
the  accountant's  task.  Accountancy  is  something 
more  than  bookkeeping.  Bookkeeping  is  the  art  of 
making  the  record  of  known  facts  in  such  shape  that 
the  record  can  be  interpreted  and  mathematical  con- 
clusions drawn.  Bookkeeping,  that  is  to  say,  assimaes 
that  the  fact  is  known  before  the  records  are  con- 
structed. Accounting,  on  the  other  hand,  is  not  an 
art  of  making  records  but  is  the  art  of  learning  the 
facts  which  bookkeeping  is  supposed  to  record.  This 
may  be  illustrated  by  a  manufacturing  business.  The 
bookkeeper  records  the  expenses  for  raw  material, 
wages,  fuel,  taxes,  rent,  interest,  insurance,  and  also 
the  returns  from  sales  of  goods.  Speaking  roughly, 
a  comparison  of  the  two  sets  of  figures  gives  the 
profit.  This  is  bookkeeping.  The  accountant,  on 
the  other  hand,  will  desire  to  know  very  much  more 
than  this.    He  will  desire  to  know  just  how  much  a 

13 


14  ACCOUIN'TING  AND  AUDITING 

dollar's  expense  in  labor  has  returned  in  product, 
how  much  every  dollar's  worth  of  goods  sold  has 
cost  in  the  factory,  what  is  the  relation  between  the 
fuel  consumed  and  the  amount  of  product,  whether 
all  the  articles  produced  show  the  same  ratio  between 
manufacturing  cost  and  selling  cost,  or  whether  the 
profit  is  very  much  larger  on  some  things  than  on 
others,  whether  the  cost  of  each  step  in  production 
is  greater  or  less  this  year  than  in  preceding  years. 
These  figures  enable  him  to  determine  three  things: 
first,  what  price  he  can  best  afford  to  put  upon  his 
product;  second,  what  is  the  most  profitable  part  of 
his  business  and  whether  any  part  is  unprofitable; 
third,  whether  the  greatest  economy  is  practiced  in 
obtaining  the  product.  He  is  concerned  also  to  see 
that  proper  allowances  are  made  periodically  for 
changing  values:  that  is  to  say,  he  is  concerned  to 
see  that  at  proper  intervals  allowance  is  made  for 
changes  in  value  of  real  estate,  merchandise  on  hand, 
machinery  and  tools,  investments,  and  innumerable 
other  things  which  share  in  the  vicissitudes  of  all 
things  earthly.  When  these  facts  have  been  deter- 
mined by  the  accountant,  it  is  a  simple  matter  for 
the  bookkeeper  to  make  them  matters  of  record. 
Thus  it  is  true,  as  already  suggested,  that  the  ac- 
countant is  concerned  with  learning  facts  which  are 
not  obvious,  and  the  bookkeeper  is  concerned  with 
recording  both  the  obvious  facts  and  those  which  the 
accountant  has  ascertained. 

The  work  of  the  accountant  cannot  be  made  me- 
chanical, nor  can  it  be  taught  by  any  rules  which  one 
may  commit  to  memory.  It  is  almost  entirely 
governed  by  judgment,  and  judgment  is  acquired 


INTRODUCTION  16 

through  experience  in  actual  business  or  through 
experience  in  dealing  with  imaginary  cases  which 
might  well  arise  in  business.  Not  all  people  have  the 
power  of  cultivating  judgment,  for  certain  qualities 
of  mind  are  essential.  These  may  be  improved  by 
education,  but  they  cannot  be  created.  It  is  true, 
however,  that  even  those  who  have  not  naturally 
good  judgment  may  as  a  result  of  education  become 
more  trustworthy  than  other  persons  of  natural  good 
judgment  who  have  not  taken  the  trouble  to  acquaint 
themselves  with  the  facts  of  business.  It  follows, 
therefore,  that  though  no  book  can  rightly  profess 
to  furnish  judgment,  and  so  to  make  accountants  out 
of  bookkeepers,  study  of  a  good  book  should  make  a 
better  bookkeeper,  and  one  who  is  capable  of  doing 
some  accounting  work,  even  out  of  one  who  is  not 
naturally  possessed  of  good  judgment;  for  so  far  as 
the  exact  problems  to  arise  can  be  studied  in  ad- 
vance, accounting  solutions  may  be  provided  in 
advance.  So  far,  however,  as  problems  arising  for 
any  accountant  are  new  to  him,  he  must  solve  them 
out  of  pure  judgment  or  from  their  similarity  to 
other  cases  of  which  the  solution  is  familiar  to  him. 
It  is  the  purpose  of  this  volume  to  take  up  the 
commoner  sorts  of  accounting  problems  in  the  vari- 
ous forms  under  which  they  are  likely  to  arise, 
and  to  work  them  through  so  as  to  furnish  illustra- 
tions for  most  of  the  simpler  cases  that  are  likely  to 
appear  in  actual  business.  It  is  impossible,  how- 
ever, that  all  kinds  of  cases  shall  be  covered,  for 
things  are  constantly  happening  in  business  unlike 
any  that  ever  occurred  before — or  at  least  unlike  any 


16  ACCOUNTING  AND  AUDITING 

that  could  have  been  foreseen  and  provided  for  by 
any  teaching. 

The  first  thing  to  do  in  an  attempt  at  education 
of  this  sort  is  to  cover  the  fundamental  principles  of 
bookkeeping.  These  are  really  only  three  in  num- 
ber. The  first  is  the  distinction  between  debit  and 
credit,  and  involves  a  determination  for  every  entry 
of  the  exact  responsibility  which  is  involved  in  the 
transaction.  The  second  fundamental  principle  is 
concerned  simply  with  the  kind  of  account  which 
shall  be  debited  or  credited  for  each  transaction;  that 
is  to  say,  not  merely  the  name  of  the  account  but  the 
use  that  shall  in  the  end  be  made  of  that  account  in 
determining  profit  and  loss  and  values  at  the  end  of 
any  period.  The  third  of  these  principles  is  con- 
cerned merely  with  the  saving  of  labor  in  so  arrang- 
ing the  books  that  the  minimum  amount  of  writing 
and  turning  of  pages  shall  give  the  maximum  in- 
formation; this  is  done  by  providing  special  columns 
and  special  books  for  special  figures,  so  that  they 
may  be  handled  in  totals  rather  than  in  small  details. 
When  these  three  principles  have  been  thoroughly 
mastered,  one  knows  practically  all  there  is  to  be 
known  about  bookkeeping.  The  remainder  of  the 
art  consists  in  applying  these  principles  to  the 
specific  conditions  found  in  any  particular  business. 
No  man  can  be  familiar  with  all  the  bookkeeping 
forms  which  may  be  best  for  all  lines  of  business, 
for  the  number  is  far  too  great.  Yet  a  man  with 
originality  and  judgment  should  be  able  for  any  busi- 
ness to  devise  a  system  on  the  three  principles  just 
mentioned. 

When  this  preliminary  study  of  bookkeeping  has 


INTRODUCTION  17 

been  made  we  may  pass  on  to  take  the  accounting 
principles — both  those  which  must  be  applied  in 
learning  the  facts  for  the  bookkeeping  entries,  and 
those  which  must  be  applied  in  interpreting  the  book- 
keeping entries  so  as  to  give  a  final  judgment  about 
the  profit  and  value  of  any  business. 


A.  &  A-i 


CHAPTER  n 

DEBIT  AND  CREDIT 

As  was  indicated  in  the  introduction,  one  of  the 
three  principles  that  cover  the  whole  of  bookkeeping 
is  the  fundamental  distinction  between  debit  and 
credit.  It  must  be  understood,  in  the  first  place,  that 
in  order  to  make  properly  a  debit  or  a  credit  one 
must  be  sure  of  the  point  of  view.  If  Jones  buys 
goods  of  Smith,  and  has  them  charged  to  his  account, 
on  Smith's  books  they  will  appear  in  a  fashion 
exactly  opposite  to  that  on  Jones's  own  books;  that 
is  to  say.  Smith's  books  must  show  that  the  money  is 
owed  by  Jones,  but  they  do  not  read  to  show  that  it 
is  owed  to  Smith,  for  Smith's  books  relate  only,  of 
course,  to  Smith's  affairs;  but  the  books  of  Jones 
must  show  that  the  money  is  owed  to  Smith,  though 
they  do  not  need  to  show  that  it  is  owed  by  Jones. 
The  same  transaction,  then,  will  be  entered  dif- 
ferently when  it  is  viewed  from  different  stand- 
points, for  always  the  books  upon  which  it  appears 
are  the  key  note  of  the  situation.  Smith's  books 
must  show  by  whom  the  money  is  owed  to  Smith's 
business,  and  Jones's  must  show  to  whom  money  is 
owed  by  Jones 's  business.  If,  in  making  an  entry  on 
Jones's  books  we  make  the  error  of  taking  the  point 
of  view  that  belongs  to  Smith's  books,  we  have 
misrepresented  the  facts.    The  first  step,  then,  in 

19 


20  AGCOUNTING  AND  AUDITING 

any  entry  is  to  see  in  what  relation  the  transaction 
stands  to  the  business  covered  by  the  books  on  which 
the  record  is  to  be  made.  It  must  be  understood 
always  that  debit  and  credit  are  always  relative, — 
that  is,  that  their  meaning  is  not  known  in  any 
particular  case  until  one  knows  on  what  set  of  books 
they  appear. 

The  basis  of  all  entries  in  the  books  of  account  is 
the  accountability  of  the  person  or  thing  named. 
This  accountability  may  arise  from  any  one  of 
several  things,  and  it  may  imply  either  a  duty  to  be 
performed  by  the  business  for  the  benefit  of  a  person 
or  thing  named  on  the  books,  or  a  duty  to  be  per- 
formed by  an  outsider,  or  by  a  special  department  of 
the  business  toward  the  business  as  a  whole.  A  duty 
to  be  performed  by  an  outsider,  or  by  a  department 
of  the  business  itself  toward  the  business  as  a  whole, 
is  always  called  a  debit,  and  is  made  through  what  is 
called  a  ^^ charge"  to  the  account  representing  that 
person  or  thing.  A  duty  to  be  performed  by  the  busi- 
ness for  an  outsider  or  for  one  of  the  business 's  own 
departments  is  always  a  credit.  We,  in  common 
language,  speak  of  a  thing  as  creditable  when  we 
mean  that  it  may  be  counted  in  the  favor  of  the 
person  or  thing  concerned.  This  is  exactly  what  we 
mean  when,  in  bookkeeping,  we  credit  an  account. 
We  may  credit  not  only  when  it  is  our  duty  to  pay 
for  the  benefit  that  we  have  received,  but  also  when 
we  wish  merely  to  record  the  fact  that  the  account 
named  has  conferred  upon  the  business  a  benefit 
which  the  business  will  keep  for  itself.  Similarly, 
in  bookkeeping,  we  debit  an  account  representing  a 
person  or  a  department  of  the  business  not  only  when 


DEBIT  AND  CEEDIT  21 

the  benefit,  which  the  business  as  a  whole  conferred, 
must  be  paid  for,  but  also  when  we  wish  merely  to 
record  the  fact  that  the  account  named  has  received 
what  the  business  sacrificed.  So,  in  any  case,  a  debit 
and  a  credit  merely  register  the  fact  that  an  account- 
ability or  a  responsibility  has  been  recognized  or 
transferred.  Debit  means  that  the  account  debited 
is  responsible  to  the  business  either  as  a  debtor  to 
repay  the  sum  debited,  as  a  repository  to  accoun<t  for 
property  intrusted  to  it,  or  as  a  force  explaining  the 
sacrifice  of  property  by  the  business.  For  illustra- 
tion, to  debit  Jones  is  to  indicate  either  that  he  must 
repay  the  money  as  a  debtor,  or  that  he  has  been 
paid  something  for  a  debt  which  the  business  owed 
him  and  so  he  must  cancel  the  debt;  to  debit  real 
estate  is  to  indicate  not  that  the  money  must  be  re- 
turned, but  merely  that  somewhere  in  connection 
with  the  business  real  property  should  be  found  to 
account  for  the  expenditure  of  the  money;  to  debit 
rent  account  is  usually  to  indicate  that  the  business 
has  sacrificed  a  certain  amount  of  value  because  of 
the  fact  that  men  cannot  normally  use  other  peoples' 
property  without  paying  for  its  use.  Similarly,  to 
credit  an  account  is  to  indicate  that  the  sum  must  be 
repaid  by  the  business  to  the  person  or  department 
represented  by  that  account,  or  that  the  business 
must  show  what  it  has  done  with  the  property  in- 
trusted to  it  on  that  account,  or  that  the  business 
force  represented  by  that  account  has  conferred  upon 
the  business  a  benefit.  Thus,  to  credit  Jones  is  to 
indicate  that  the  business  owes  him  or  that  he  has 
paid  something  which  he  owed  to  the  business;  to 
credit  real  estate  is  to  indicate  that  the  property  has 


22  ACCOUNTING  AND  AUDITING 

surrendered  to  the  business  a  certain  amount  of 
value;  and  to  credit  interest  account  is  to  indicate 
that  the  force  in  business  which  requires  men  to  pay 
for  the  use  of  others'  money  has  brought  in  income. 
To  summarize  this  principle,  then,  we  may  say  that 
when  any  transaction  has  occurred  such  that  some 
person  or  department  of  the  business  or  business 
force  is  responsible  for  property,  whether  for  the 
receipt  and  care  of  that  property  or  for  the  loss  of 
that  property,  we  should  debit  the  account  represent- 
ing that  person  or  department  or  force;  when  a  trans- 
action is  such  that  any  person  or  department  of  the 
business  has  conferred  a  benefit  on  the  business  as  a 
whole — which  is,  of  course,  a  creditable  thing  to  do, 
— we  should  credit  the  account  representing  that  per- 
son, department,  or  force. 

With  this  general  statement  as  a  starting  point, 
we  may  now  pass  on  to  illustrate  the  principle  with 
a  good  many  detailed  cases  and  see  how  it  works  out 
in  practice. 

If  we  sell  goods  on  trust,  we  wish  to  record  on 
our  books  the  fact  that  someone  is  responsible  to 
make  payment  to  us  for  their  value.  It  is  inevitable, 
therefore,  that  we  shall  debit  someone,  for  a  debit 
means  that  the  person  named  in  the  title  of  the 
account  is  responsible  or  accountable  to  the  business. 
It  is  customary  in  naming  an  account  to  indicate 
clearly  who  or  what  is  connected  with  the  responsi- 
bility indicated  by  that  account.  For  instance,  in  the 
case  just  mentioned,  we  must  give  to  the  account  a 
name  which  wUl  indicate  not  merely  the  fact  that 
this  money  is  owed  by  a  person,  but  also  in  what 
capacity  that  person  owes  the  money.    It  may  be 


DEBIT  AND  CREDIT  23 

some  other  capacity  than  that  of  a  private  individual. 
If  John  Jones,  for  instance,  buys  goods  as  a  trustee, 
we  should  debit  not  John  Jones,  but  *^John  Jones, 
Trustee,^'  to  indicate  that  the  claim  is  not  against 
him  as  an  individual  but  against  him  as  a  representa- 
tive of  someone  else.  If,  on  the  other  hand,  he 
makes  the  purchase  for  a  society,  and  has  its  author- 
ity to  make  such  a  purchase,  we  should  debit  the 
society  itself;  for  to  that  society  we  may  look  for 
payment.  If,  again,  the  purchase  is  made  by  John 
Jones  for  the  firm  of  John  Jones  &  Company,  care 
must  be  taken  that  the  debit  is  made  not  to  ^^John 
Jones,"  but  to  ^'John  Jones  &  Company,"  for  he 
personally  is  liable  only  in  case  the  firm  of  John 
Jones  &  Company  fails  to  pay.  The  books  should 
show  the  legal  relation  between  the  business  for 
which  they  are  kept  and  the  outside  world. 

The  relations  of  a  business  are  much  more  ex- 
tensive, however,  than  merely  with  outsiders.  Of 
course,  looking  at  the  thing  in  the  simplest  point  of 
view,  the  total  property  of  a  concern  less  the  claims 
against  it  is  the  present  worth  of  the  business  as  a 
whole;  but  if  we  have  no  figures  on  our  books  other 
than  the  total  of  the  property  and  the  claims  against 
outsiders  (less  the  claims  which  outsiders  have 
against  the  business),  though  we  may  know  what  the 
business  is  worth,  we  shall  not  know  where  to  look 
to  find  that  value.  Some  of  it  may  be  in  cash,  some 
of  it  in  merchandise,  some  of  it  in  notes,  some  of  it 
in  real  estate,  and  some  of  it,  as  we  have  seen,  in 
claims  against  outsiders.  If  the  books  are  to  show 
the  facts,  they  ought  to  show  not  only  what  claims 
we  have  against  outsiders,  which  are,  of  course,  the 


24  ACCOUNTING  AND  AUDITING 

same  as  property,  but  also  what  kinds  of  property 
there  are  in  the  business  and  what  is  the  value  of 
each  kind. 

This  can  be  done  only  if  we  keep  an  account  with 
each  kind  of  property,  indicating  for  every  entry 
the  value  connected  with  each  transaction.  That  is 
to  say,  accounts  should  show  how  much  cash  is  on 
hand,  what  is  the  value  of  real  estate,  what  is  the 
value  of  merchandise,  what  is  the  face  value  of  prom- 
issory notes,  etc.  It  happens  that  these  facts  can 
be  very  easily  recorded  by  treating  various  depart- 
ments of  the  business  itself  as  if  thay  were  actually 
individuals  outside  the  business.  For  instance,  if 
we  treat  the  cashier's  department  as  if  it  were  an 
outsider,  or  as  if  the  cashier  were  an  outsider  who 
had  relations  with  the  business,  we  can  show  the 
amount  of  cash  received,  for  we  can  charge  or  debit 
cash  account  as  responsible  for  all  money  entrusted 
to  the  cashier  exactly  as  we  should  charge  an  out- 
sider for  money  paid  to  him;  and  if  we  credit  cash 
account  for  all  money  paid  out,  just  as  we  should 
credit  an  outside  person  who  supplied  us  with  cash, 
the  total  credit  will  represent  the  payments.  The 
difference  between  the  two  sides  will  show  the 
amount  of  cash  that  ought  to  be  on  hand.  In  other 
words,  though  the  cash  drawer  is  a  part  of  the  busi- 
ness, we  can  best  get  the  figures  that  we  want  by 
treating  it  on  the  books  as  if  it  were  an  outside 
person. 

Similarly,  if  we  debit  merchandise  account  for  aU 
goods  purchased,  treating  it  as  if  it  represented  an 
outside  warehouse  which  we  had  entrusted  with 
goods,  our  total  debits  to  merchandise  account  will 


DEBIT  AND  CEEDIT  25 

show  the  amount  of  purchases  and  by  so  much  the 
amount  which  the  warehouse  must  be  able  to  ac- 
count for  to  the  business  as  a  whole;  and  if  we  credit 
merchandise  account,  representing  the  warehouse, 
exactly  as  if  it  were  outside,  the  total  credits  to  mer- 
chandise account  will  represent  the  amount  which 
the  warehouse  has  surrendered.  The  balance  will 
be,  if  we  have  debited  and  credited  all  goods  at  the 
same  price,  the  balance  of  merchandise  that  should 
remain  in  the  warehouse.  So  we  can,  by  treating 
departments  of  the  business  as  if  they  were  responsi- 
ble for  property  exactly  as  outsiders  are  responsible, 
secure  figures  which  shall  show  in  detail  the  distri- 
bution of  the  property  of  the  business  through  its 
various  departments.  When,  therefore,  as  assumed 
a  moment  ago,  we  debit  John  Jones,  or  John  Jones, 
Trustee,  or  John  Jones  &  Company,  for  the  sale  of 
goods,  we  should  also  credit  Merchandise;  for  the 
warehouse,  represented  by  the  merchandise  account, 
has  given  up  to  the  business  merchandise  which  has 
now  passed  over  to  John  Jones.  So,  in  effect,  what 
has  happened  is  that  whereas  previously  merchan- 
dise account,  representing  the  warehouse,  was  re- 
sponsible to  us  for  certain  value  in  merchandise, 
now  that  responsibility  has  been  taken  by  John 
Jones  and  the  warehouse  has  given  it  up.  The  books 
show  this  exactly  as  it  has  happened.  There  is  no 
longer  a  responsibility,  so  far  as  this  merchandise  is 
concerned,  on  the  warehouse  account,  but  one 
attaches  to  the  account  of  John  Jones. 

One  class  of  accounts  representing  relations 
within  the  business  still  remains.  Sometimes  we 
make  payments  or  receive  property  in  return  not 


26  ACCOUNTING  AND  AUDITING 

for  other  property,  such  as  exchange  of  merchandise 
for  cash,  but  on  account  of  some  force  in  business 
which  causes  profit  or  loss.  For  instance,  if  we 
borrow  money  we  are  pledged  to  pay  interest  for  its 
use.  When  we  pay  that  interest  we  pay  it  not  for  a 
thing  which  can  be  seen  or  touched,  but  merely  be- 
cause there  is  in  our  civilization  a  force  which  re- 
quires us  to  make  a  payment  for  the  use  of  other 
people's  property.  This  payment  of  interest  has 
not  affected  the  amount  we  owe  on  the  original  loan. 
If  we  borrow  $1,000  with  an  agreement  to  pay  six 
per  cent,  interest,  we  pay  at  the  end  of  two  months, 
when  the  money  becomes  due,  $1,010,  of  which  $1,000 
is  a  repayment  of  the  original  sum  and  the  $10  repre- 
sents no  repayment  but  a  mere  compensation  for  the 
use  of  the  $1,000.  Obviously,  this  $10  cannot  be  deb- 
ited to  any  of  the  accounts  that  we  have  previously 
considered.  It  cannot  be  debited  to  the  man  who  lent 
us  the  money,  for  he  is  under  no  obligation  to  return 
it  or  to  account  for  it.  We  have  owed  it  to  him  be- 
cause of  using  his  thousand  dollars,  and  when  we  pay 
it  we  simply  meet  our  obligation.  To  debit  it  to  him 
would  be  to  tell  a  falsehood  on  our  books,  for  it  would 
imply  that  he  is  now  responsible  to  account  for  that 
$10,  and  he  is  not.  We  cannot,  on  the  other  hand, 
debit  that  $10  to  any  property  account,  such  as  those 
discussed  in  the  last  paragraph,  for  that  $10  does 
not  to  us  represent  any  property;  it  is  not  cash,  nor 
merchandise,  nor  real  estate,  nor  notes.  It  has  sim- 
ply disappeared  in  consequence  of  the  fact  that  men 
must  pay  for  the  use  of  other  people 's  property.  The 
same  sort  of  thing  is  true  with  regard  to  payments 
of  rent,  of  taxes,  of  wages,  of  postage;  indeed,  it  is 


DEBIT  AND  CREDIT  27 

true  of  all  payments  for  which  we  do  not  get  prop- 
erty in  exchange. 

If  we  did  not  care  at  the  end  of  the  year  to  know 
anything  more  about  our  profit  or  loss  than  the 
amount  of  such  profit  or  loss,  th^re  would  be  no  need 
of  keeping  record  of  these  payments,  for,  as  has 
already  been  indicated,  the  difference  between  our 
property  and  claims  at  the  beginning  of  the  year  and 
the  property  and  claims  at  the  end  of  the  year  indi- 
cates the  profit;  but  if  we  wish  to  know  from  what 
sources  our  profits  have  come,  and  for  what  reasons 
we  have  suffered  certain  losses  or  certain  expenses, 
it  is  necessary  for  us  to  keep  a  record  through  the  year 
of  the  particular  forces  which  have  brought  income 
or  have  caused  us  to  suffer  loss  and  expense.  We 
can  keep  such  records  by  a  process  similar  to  that 
of  keeping  account  of  our  property.  Remembering 
that  ** debit"  means  that  the  account  named  and 
debited  is  responsible,  we  see  that  to  debit  one  of 
these  force  accounts  such  as  Interest  is  to  hold  that 
force  responsible  or  accountable  for  the  loss  of  prop- 
erty. Although  it  is  not  true  that  those  forces  can 
usually  return  to  us  the  property  debited,  it  is  true 
that  those  forces  are  responsible  for  the  loss  in  the 
sense  in  which  we  commonly  use  ** responsible"  in 
everyday  talk.  We  commonly  say  that  the  cold 
weather  is  responsible  for  prevalent  sickness,  or 
trusts  are  responsible  for  high  prices.  We  can  very 
well  use  ^'responsibility"  in  this  sense  for  bookkeep- 
ing purposes ;  and  so  we  make  record  of  the  fact  that 
a  loss  of  cash  is  due  to  that  force  in  business  called 
*  interest,"  and  we  debit  Interest  even  though  we 
do  not  expect  that  force  to  return  the  money.    In 


28  ACCOUNTING  AND  AUDITING 

other  words,  a  debit  to  Interest  in  this  fashion  is 
simply  a  record  of  the  explanation  of  the  loss  of 
cash,  and  all  debits  and  credits  to  such  accounts  are 
of  the  nature  of  explanations.  As  has  already  been 
suggested,  we  desire  to  know  at  the  end  of  the  year 
not  only  what  our  profit  or  loss  has  actually  been, 
but  what  were  the  sources  of  profit  and  the  causes  of 
loss. 

Obviously,  if  we  had  done  nothing  throughout 
the  year  but  exchange  property  of  one  sort  for  prop- 
erty of  another  and  of  the  same  value,  we  should 
neither  have  made  profit  nor  suffered  loss.  If  profits 
or  losses  have  resulted,  something  different  from 
mere  exchange  at  the  same  price  has  occurred.  We 
desire  to  know  not  only  what  exchanges  have  taken 
place,  but  also  why  there  has  been  a  difference  of 
value  between  the  property  given  and  the  property 
received.  Accounts  can  furnish  us  just  the  desired 
explanations.  Under  the  head  of  Interest,  for  in- 
stance, they  can  give  figures  showing  how  much  cash 
went  out  and  came  in  for  interest,  which  is  not  a 
tangible  thing — though  the  use  of  the  money  bor- 
rowed or  lent  may  have  made  possible  a  profit  which 
will  be  registered  finally  in  some  property  account. 
Similarly,  if  we  have  bought  merchandise  at  one  price 
and  sold  it  at  another,  the  difference  between  the  two 
prices  may  be  shown  in  some  explanation  account. 

It  will  be  noted  that  these  explanation  accounts 
never  represent  value.  They  show  only  an  amount 
of  change  in  values.  When  we  paid  cash  for  interest, 
we  were  giving  something  of  tangible  value  in  return 
for  a  thing  which  for  that  particular  moment  of 
exchange  brought  nothing  in  return — though  its  use 


DEBIT  AND  CEEDIT  29 

in  the  past  may  have  brought  profit  registered  in 
some  other  account.  In  the  case  of  a  purchase  and  a 
sale  of  merchandise,  as  we  have  seen,  Merchandise 
should  have  been  debited  for  the  goods  purchased, 
at  the  cost  price,  and  credited  for  the  goods  sold,  at 
the  selling  price;  the  difference  between  these  two 
amounts  will  be  the  profit  which  must  be  recorded  in 
some  explanation  account.  Let  us  say  that  cash  was 
paid  for  merchandise  bought,  and  was  received  for 
that  sold.  We  can  show  the  meaning  of  the  explana- 
tion account  by  supposing  both  purchase  and  sale 
to  take  place  at  the  same  time.  Our  entries  then 
will  be — 

Merchandise,  Dr.,  $3,000 

To  Cash,  Cr.,  $3,000 

Cash,  Dr.,  3,500 

To  Merchandise,  Cr.,  3,000 

To  Profit  &  Loss,  Cr.,  500 

These  three  accounts  show  that  merchandise  to 
the  amount  of  $3,000  was  received  and  charged  to  the 
warehouse,  and  later  the  warehouse  surrendered 
$3,000  worth  of  merchandise  and.  was  accordingly 
credited;  that  cash  to  the  amount  of  $3,000  was  paid 
out,  and  later  cash  to  the  amount  of  $3,500  came  in 
and  was  debited  to  the  cashier's  department;  and, 
finally,  that  the  difference  between  the  $3,000  cash 
going  out  and  the  $8,500  cash  coming  in  is  explained 
by  the  profit  and  loss  account  representing  gains  and 
losses  from  the  forces  of  business.  In  practice,  it  is 
common  to  keep  a  good  many  separate  accounts  for 
profit  and  loss,  each  indicating  some  special  sort  of 
gain  or  loss,  such  as  interest,  rent,  insurance,  taxes, 
wages,  postage,  commissions,  stationery,  printing, 


30  A.CCOUXTING  AND  AUDITING 

cartage,  freight,  etc.  Some  of  these  represent  ex- 
pense, and  are  usually  debited  as  responsible;  and 
others  represent  earnings,  and  are  usually  credited 
as  conferring  benefit  on  the  business — a  creditable 
thing  to  do. 

We  have  seen,  then,  three  kinds  of  accounts — 
first,  with  persons,  partnerships,  corporations  and 
others,  who  are  entirely  outside  of  the  business  and 
have  relations  of  responsibility  or  accountability  with 
it,  in  which  they  are  responsible  to  the  business  or  it 
is  responsible  to  them;  these  are  usually  called  per- 
sonal accounts:  second,  accounts  representing  vari- 
ous departments  of  the  business  which  contain  prop- 
erty belonging  to  the  business,  such  as  merchandise, 
real  estate,  cash,  bills  receivable,  etc. ;  these  are  usu- 
ally called  property  accounts:  these  two  classes  to- 
gether are  usually  called  real  accounts:  ^ third,  ac- 
counts representing  forces  which  cause  profit  or  loss, 
explanatory  of  changes  in  value,  such  as  interest,  in- 
surance, taxes,  etc. ;  these  are  usually  called  nominal 
accounts,  for  they  represent  forces,  or  names,  rather 
than  things. 

When  one  stops  to  think  of  it,  one  sees  that  it  is 
impossible  ever  to  have  a  debit  without  the  need,  if 
the  books  are  to  be  carefully  kept,  of  a  credit  some- 
where to  correspond.  We  have  seen  that  all  transac- 
tions are  either  mere  exchanges  of  one  kind  of  prop- 
erty for  another,  or  payments  or  receipts  of  prop- 
erty because  of  one  of  the  forces  in  business  which 
calls  one  to  get  or  give  more  or  less  than  the  exact 
equivalent.  If  we  do  not  exchange  dollar  for  dollar, 
which,  of  course,  yields  no  profit  or  loss,  we  are  giv- 
ing more  or  less,  and  therefore,  getting  profit  or  suf- 


DEBIT  AND  CREDIT  31 

fering  loss;  and  one  of  the  purposes  of  our  account- 
ing is  to  show  not  only  what  we  get  and  give,  but 
why  we  get  and  give  it.  If  there  has  been  an  in- 
crease or  a  decrease,  some  one  of  the  forces  which 
causes  increase  or  decrease  has  been  at  work,  and 
our  books  should  show  which  cause  was  responsible 
for  the  loss  or  creditable  for  the  gain.  It  is  neces- 
sary, therefore,  that  when  anything  is  debited  as  re- 
sponsible for  value,  something  else  shall  be  to  the 
same  amount  credited  for  furnishing  either  the  value 
which  was  exchanged  or  the  force  which  caused  the 
increase  in  value;  and  it  is  similarly  necessary  that 
when  anything  is  credited  as  yielding  value,  some- 
thing else  shall  be  debited  as  either  taking  guardian- 
ship or  explaining  the  origin  of  the  loss.  For  in- 
stance, if  we  credit  Cash  for  a  payment  of  money,  we 
must  debit  the  person  receiving  the  money,  the 
account  representing  the  property  purchased  with 
the  money,  "or  the  account  showing  the  money  lost; 
if  we  fail  to  do  this  we  have  not  recorded  all  the  facts 
worth  knowing.  Similarly,  if  we  debit  Cash  for 
money  received,  we  must  credit  the  person  furnish- 
ing the  cash,  the  property  account  which  gave  up  the 
property  sold  for  the  cash,  or  the  nominal  account 
which  explains  through  what  force  the  cash  was 
earned.  This  is  the  origin  of  double-entry  bookkeep- 
ing. This  is  all  that  is  meant  by  double-entry  book- 
keeping— namely,  that  for  every  debit  there  is  a 
credit  of  the  same  amount  to  some  one  or  more  ac- 
counts ;  otherwise,  the  origin  of  the  debit  has  not  been 
shown  and  the  books  fail  to  record  all  they  should. 
Single-entry  bookkeeping,  on  the  other  hand,  at- 
tempts to  record  usually  only  the  relations  of  the  busi- 


3!^  ACCOUNTma  AND  AUDITIKG 

ness  with  outsiders,  and  gives  no  information  about 
the  sources  of  profit  or  loss — and  sometimes  gives 
practically  none  about  the  kinds  of  property  in  the 
business.  Since  practically  all  business  records  which 
profess  to  seek  accuracy  must,  from  the  nature  of  the 
case,  be  kept  by  double  entry  in  order  to  tell  all  the 
facts,  it  is  to  double  entry  that  we  shall  devote  our 
attention  here. 

Let  us  summarize,  finally,  our  conclusions  with 
regard  to  debit  and  credit.  To  debit  is  to  indicate 
that  the  account  named,  which  must  represent  per- 
sons, property,  or  a  force,  is  held  by  the  business 
responsible  for  the  amount  of  value  indicated  by  the 
entry.  It  does  not  necessarily  mean,  however,  that 
the  amount  is  to  be  repaid;  for  in  the  case  of  a  per- 
sonal account,  a  previous  credit  may  have  indicated 
that  the  money  was  already  owed  and  this  debit  now 
show^s  merely  that  the  matter  is  closed,  and  in  the 
case  of  a  nominal  account,  the  business  does  not  ex- 
pect the  value  to  be  returned  because  it  is  recog- 
nized as  one  of  the  definite  expenses  or  losses  to  be 
offset  against  gains  at  the  end  of  the  year.  A  credit, 
on  the  other  hand,  is  an  acknowledgment  that  the 
account  named  has  conferred  certain  benefits  for 
which  it  is  creditable.  It  is  not  true,  necessarily, 
that  the  business  must  ever  pay  for  those  benefits; 
for  a  credit  to  a  personal  account  may  simply  offset 
a  debit  previously  made,  and  indicate  only  that  a 
debt  incurred  toward  the  business  has  now  been  paid, 
or,  in  the  case  of  a  nominal  account,  it  may  indicate 
that  this  force  has  brought  into  the  business  certain 
income  which  the  business  will  keep  as  its  own  profit. 


CHAPTER  ni 

THE  METHOD  OF  IJNTRY 

It  would  be  possible  to  keep  books  in  the  form  of 
a  diary  written  in  narrative  form,  just  as  it  is  pos- 
sible for  a  person  to  make  detailed  financial  state- 
ments by  word  of  mouth.  It  is  obvious,  however, 
that,  though  the  facts  might  be  all  contained  in  such 
a  narrative,  drawing  conclusions  from  those  facts 
would  be  extremely  difficult.  If,  moreover,  one 
should  happen  to  miss  some  important  fact  in  draw- 
ing one's  conclusions  or  in  making  a  settlement  with 
an  outsider,  the  record  might  just  as  well  be  faulty 
as  to  be  correct,  for  an  item  missed  is,  for  the  pur- 
pose in  hand,  an  item  lost.  It  is  essential,  then,  that 
the  figures  shall  be  brought  together  so  that  all 
items  relating  to  the  same  thing  may  be  added  to- 
gether or  subtracted  one  from  another  to  produce 
a  correct  total  or  balance.  The  ultimate  destina- 
tion of  all  figures  in  bookkeeping,  then,  is  a  book 
in  which  the  items  may  be  classified  according  to 
their  relations.  This  book  is  in  practice  always 
called  the  *  ledger,"  and  it  is  so  arranged  that  each 
account  has  a  page  (or  several  pages,  or  a  portion 
of  a  page)  to  itself,  and  all  debits  are  written  in  the 
left  half  of  the  space  and  all  credits  in  the  right. 
The  ledger  must  recognize  the  principle,  stated  in 
the  last  chapter,  that  the  debit  shall  be  to  a  title 

A  &  A-3  33 


34  ACCOUNTING  AND  AUDITING^ 

expressing  the  exact  relation  to  the  business,  and 
not  confuse  ^^John  Jones''  v/ith  ^'John  Jones, 
Trustee,''  or  with  ''John  Jones  &  Company."  There 
may  then  be  three  accounts  in  the  ledger  all  of  which 
represent  the  relations  of  the  business  with  John 
Jones,  but  each  will  represent  him  in  a  capacity 
somewhat  different  from  any  of  the  others.  By  an 
''account"  we  always  mean  the  items  to  be  brought 
together  in  the  ledger,  and  hence  if  for  any  reason 
we  wish  to  distinguish  items  which  are  apparently 
of  the  same  sort,  we  may  open  separate  accounts  in 
the  ledger  lest  they  be  confused;  but  always  the  title 
finally  chosen  for  any  account  should  be  used 
throughout  all  the  books  for  all  items  to  be  carried 
to  that  account  in  the  ledger. 

Since  the  ultimate  destination  of  all  figures  is 
the  ledger,  we  must  arrange  our  books  in  such 
fashion  that  we  shall  at  the  same  time  make  clear 
the  meaning  of  the  original  record,  which  is  good 
legal  evidence  of  facts,  and  keep  the  items  in  such 
form  that  they  can  be  easily  transferred  to  the 
ledger  without  risk  of  omission  or  confusion.  This 
is  usually  accomplished  by  making  every  entry  in 
two  parts:  one  is  a  statement  in  rough  diary  form 
giving  the  history  of  the  transaction  so  that  it  shall 
be  clear  to  everyone  reading  it  even  though  he  is 
unacquainted  with  the  transaction  itself;  the  other 
is  a  brief  summary  which  gives  the  names  of  the 
accounts  to  be  debited,  the  names  of  the  accounts  to 
be, credited,  and  the  amounts  for  each.  In  the  old 
days,  these  two  portions  of  an  entry  were  custom- 
arily kept  in  separate  books,  the  first  of  which  was 


THE  METHOD  OF  ENTHY  35 

commonly  called  the  '^daj  book,"  and  the  second 
the  '^journal.''  As  a  consequence,  the  brief  sum- 
mary formerly  kept  in  the  journal  has  come  to  be 
called  the  ^'journalization."  Its  purpose  is  to 
serve  as  a  medium  to  assist  in  transferring  from  the 
diary  form  of  the  original  record  to  the  classifica- 
tion in  the  ledger,  i.  e.,  in  '^ posting."  This  journaliza- 
tion would  be  entirely  unnecessary  if  it  were  not 
for  the  fact  that  often  a  transaction  is  so  compli- 
cated that,  in  attempting  to  transfer  items  to  the 
ledger,  i.  e.,  to  post,  from  the  diary  form,  one  is  in 
great  danger  of  omitting  some  item  from  either  the 
debit  or  the  credit  side,  or  of  neglecting  some  por- 
tion of  a  divided  item.  For  instance,  if  we  give  cash 
to  pay  a  bill  and  to  pay  a  note  at  the  same  time, 
the  entry  may  include  a  debit  to  our  creditor  for 
the  amount  of  the  bill,  a  debit  to  Bills  Payable  for 
the  amount  of  the  note,  a  debit  to  Interest  for  the 
interest  on  the  note,  a  credit  to  Cash  for  the  amount 
of  cash  paid,  and  a  credit  to  Discount  for  the  amount 
of  discount  allowed  on  the  bill;  that  i^,  though  on  the 
face  of  it  we  have  only  to  debit  Bills  Payable  and 
the  creditor,  and  to  credit  Cash,  we  have  really  in  ad- 
dition to  get  upon  our  ledger  a  debit  to  Interest  and 
a  credit  to  Discount.  It  would  be  practically  impos- 
sible for  any  bookkeeper  to  make  such  postings  from 
a  simple  diary  form  of  statement  and  keep  up  the 
process  hour  after  hour  without  many  errors  of 
commission  or  omission.  The  security  against  this 
is  journalization  of  entries  in  summary  form.  Such 
a  transaction  as  that  just  described  might  be  en- 
tered in  a  modern  journal  as  foUows: 


36  ACCOUNTTT^G  AND  AUDITING 

Paid  John  Doe  today  his  bill  of  N  ovember  18,  less  2% 
discount,  and  our  note  dated  October  18,  with  in- 
terest, at  6%. 
John  Doe  $200 

Bills  Payable  300 

Interest  3 

To  Cash  $499 

Discount  4 

As  a  matter  of  universal  custom,  debits  are  writ- 
ten in  the  journal  in  left  columns,  and  credits  in 
right. 

The  form  of  entry  just  illustrated  makes  it  pos- 
sible to  keep  all  details  of  business  transactions  in 
a  form  not  only  clear  for  a  statement,  but,  at  the 
same  time,  if  the  amounts  stand  out  prominently, 
ready  for  use  in  posting  to  the  ledger;  so  far,  they 
are  quite  as  good  as  any  bookkeeping  forms  need  to 
be.  In  reality,  however,  many  devices  have  been  in- 
vented for  simplifying  the  labor  of  making  and  find- 
ing and  interpreting  entries  and  of  posting  from  the 
journalization  to  the  ledger.  For  instance,  it  is  a 
great  convenience  to  have  all  cash  items  together, 
not  only  in  the  ledger  but  in  the  books  of  original 
entry,  so  that  all  explanations  of  just  what  was  done 
with  cash  and  why  it  was  received  shall  appear 
together.  This  is  usually  done  by  providing  a  book 
into  which  nothing  shall  go  but  cash  transactions. 
Similarly,  it  is  convenient  to  have  together  in  one 
book  all  sales  of  merchandise,  and  this  is  the  cus- 
tom in  all  but  small  businesses.  The  title  of  such  a 
book  is  usually  the  *^ sales  book.''  Purchases  are 
very  commonly  also  kept  in  a  book  by  themselves, 
which  may  be  called  the  "invoice  book''  or  the 
** purchase  book." 


THE  METHOD  OF  ENTEY  37 

It  can  be  readily  seen  that  if  items  of  one  sort 
are  kept  together,  as  in  a  cash  book,  a  sales  book, 
and  a  purchase  book,  the  labor  of  posting  may  be 
very  much  simplified.  When  we  make  entries  in 
the  journal  form  just  described.  Cash  must  be  debited 
by  a  posting  to  the  ledger  for  each  cash  receipt  and 
must  be  credited  by  a  posting  to  the  ledger  for  each 
cash  payment ;  and  at  the  same  time  a  credit  posting 
must  be  made  to  some  other  account  for  each  debit 
to  Cash,  and  a  debit  posting  must  be  made  to  some 
other  account  for  each  credit  to  Cash.  In  other 
words,  fifty  receipts  of  cash  would  mean  one  hun- 
dred postings — fifty  debits  to  Cash  and  fifty  credits 
to  other  accounts ;  and  fifty  pajments  of  cash  would 
mean  one  hundred  postings — fifty  debits  to  other 
accounts  and  fifty  credits  to  Cash.  "When,  on  the 
other  hand,  we  keep  all  cash  items  in  a  book 
by  themselves,  we  do  not  need  to  post  to  the  ledger 
each  individual  debit  and  credit  to  Cash,  but  may 
hold  back  the  postings  to  Cash  in  the  general  ledger 
as  long  as  we  like,  provided  only  we  realize  all  the 
time  that  the  total  of  all  cash  receipts  is  a  cash  debit 
and  the  total  of  all  cash  payments  is  a  cash  credit 
w^hich  ultimately  must  be  considered  in  judging  the 
business.  Indeed,  if  we  like,  we  may  wait  until  the 
end  of  the  month  before  we  post  any  item  to  Cash, 
and  then  we  may  post  to  each  side  of  Cash  the  total 
for  the  month  of  all  items  on  that  side,  instead  of 
the  fifty  or  more  separate  items  to  each  side.  We 
still  have,  however,  to  post  the  other  half  of  all  cash 
entries, — that  is,  the  debits  to  other  accounts,  to  ex- 
plain why  cash  w^ent  out,  and  the  credits  to  other  ac- 
counts to  explain  why  cash  came  in.    We  have  not 


38  ACCOUNTING  AND  AUDITING 

reduced  the  labor  of  posting^  any  account  but 
Cash,  but  we  have  reduced  that  from  say  fifty 
postings  a  month  to  one.  Similarly,  if  all  our  Mer- 
chandise debits  are  in  the  purchase  book,  though  we 
must  credit  in  the  ledger  each  seller  with  what  we 
have  received  from  him,  we  do  not  need  to  post  the 
debit  to  Merchandise  item  by  item  but  may  hold 
back  those  postings  until  the  end  of  the  month,  or 
such  time  as  we  please,  and  then  post  them  in  total 
as  the  footings  of  the  page  or  pages  of  the  purchase 
book.  With  the  sales  book,  similarly,  the  total  of 
the  book  is  the  credit  to  Merchandise,  and  it  may  be 
"posted  in  a  lump  sum;  but  the  debits  to  customers 
must  be  posted  item  by  item. 

It  is  obvious  that  with  a  separate  book  for  cash, 
for  purchases,  and  for  sales,  our  original  book  of 
record,  the  journal,  has  shrunk  to  rather  insignifi- 
cant dimensions.  The  journal  still  serves  an  im- 
portant function  because  items  of  interest,  discounts, 
transfers  from  one  account  to  another,  and  all  other 
transactions  which  are  not  directly  cash  or  merchan- 
dise, must  go  upon  its  pages. 

It  is  now  worth  while  to  observe  the  forms  which 
are  in  common  use.  The  journal,  nowadays  rather 
insignificant  in  size,  though  very  important  with  re- 
gard to  the  kind  of  items  which  it  contains,  may  be 
of  numerous  forms,  equally  good  in  theory,  but  each 
good  or  bad  according  to  the  needs  of  the  particular 
'business  in  which  it  is  used.  There  is,  in  fact,  no 
such  thing  as  an  absolutely  right  or  absolutely  wrong 
form  anywhere  in  bookkeeping.  Any  form  is  right 
which  states  clearly  the  transaction.  The  choice  be- 
tween forms  is  determined  by  the  ease  with  which 


THE  METHOD  OF  EI^TEY  39 

each  can  be  handled,  and  that  is  determined  not 
merely  by  its  adaptation  to  speed  in  making  trans- 
fers or  postings  to  the  ledger,  but  by  its  provisions 
against  confusion.  The  form  given  above,  on 
page  36,  in  which  we  have  first  the  detailed  descrip- 
tion of  the  transaction  and  then  the  journalization, 
is  logically  the  best,  for  the  journalization  or  sum- 
mary statement  arises  out  of  the  detailed  description 
of  the  transaction.  In  practice,  however,  it  is  usu- 
ally found  a  little  less  convenient  to  handle  than  the 
reverse  form,  in  which  the  journalization  is  stated 
first.  The  difference  lies  simply  in  the  fact  that 
items  to  be  posted  stand  out  more  distinctly  at  the 
beginning  of  an  entry  than  when  they  follow  an  ex- 
planation. Some  bookkeepers  may  find  the  first 
form  for  their  particular  eyes  more  easy  to  work 
from.  Another  form  very  convenient  is  one  in  which 
the  journalization  stands  in  a  column  parallel  to  the 
explanation.  This  form  often  saves  the  rewriting 
of  figures  and  of  names,  for  the  journalization  may 
follow  line  for  line  the  explanation  to  which  it  be- 
longs. Its  defect  is  sometimes  awkwardness  of  ar- 
rangement. An  illustration  of  the  second  form  will 
be  found  on  page  75,  and  one  of  the  third  form  on 
page  41.  It  should  be  clearly  understood  that  there 
is  no  difference  in  desirability  between  these  forms 
except  as  one  of  them  may  prove  for  any  particular 
bookkeeper  easier  for  him  to  work  from.  Usually, 
in  all  forms,  a  blank  line,  or  a  line  used  only  for  the 
date,  is  left  between  entries.  This  arrangement 
makes  clear  to  the  eye  just  how  much  is  comprised 
in  each  entry. 

It  was  common  many  years  ago,  and  some  book- 


40  ACCOUNTING  AND  AUDITING 

keepers  still  keep  up  the  custom,  to  use  the  term 
*^ Sundries"  on  a  journal  whenever  more  than  one 
item  appears  on  either  debit  or  credit  side  of  an 
entry.  If,  for  instance,  we  have  a  debit  to  custom- 
ers and  a  credit  to  Merchandise,  the  entry  would 
normally  be  made  to  read: 

Sundries 

To  Merchandise  500.00 

David  Hume  250.00 

Edward  Gibbon  250.00 

This  means  that  the  debit  is  not  to  one  account 
but  to  two,  and  that  the  equality  between  debits  and 
credits  must  be  looked  for  not  between  the  credit 
and  any  one  debit,  but  between  the  credit  and  a 
group  of  debits.  The  same  sort  of  thing  would  be 
true  if  the  matter  were  reversed.  Indeed,  the  entry 
may  read  even  '* Sundries  to  Sundries,"  when  on 
both  sides  appears  more  than  one  item.  Such,  for 
instance,  would  be  the  case  if  we  had  given  cash  as 
well  as  merchandise  to  Hume  and  Gibbon,  as  follows : 

Sundries 

To  Sundries 
David  Hume  600 

Edward  Gibbon  600 

Cash  600 

Merchandise  500 

The  details  would,  of  course,  be  explained  in  the 
day-book  portion  of  the  entry,  indicating  how  much 
cash  and  how  much  merchandise  was  given  to  each. 

An  illustration  of  the  parallel-coliunn  form  of 
journal,  without  the  use  of  the  term  ^^ Sundries,"  is 
given  below.  It  may  well  be  compared  with  the 
original  form  given  on  page  36. 


THE  METHOD  OF  ENTEY 
[Journal — Parallel-column  form] 


John  Doe 
Bills   Payable 
Interest 
To   Cash 
To   Discount 


DEC.  18. 
His  bill  of  Nov.  18 
Our  note  of  Oct.   18 
On  note  of  Oct.  18 
Paid  as  above 
Less  2%  on  the  bill 


200 

300 
3 


41 


499 
4 


It  is  obvious  that  wlien  we  turn  to  the  cash  book, 
which,  as  was  just  indicated,  contains  only  cash 
items,  it  is  unnecessary  to  provide  a  complete  jour- 
nalization. The  fact  that  the  item  appears  upon  the 
cash  book  sufficiently  indicates  that  Cash  is  either 
debited  or  credited.  If  we  divide  the  cash  book  it- 
self into  two  parts,  using  left  pages,  as  the  book  lies 
open,  for  debits  to  Cash,  and  right  pages  for  credits 
to  Cash,  we  have  by  the  mere  choice  of  pages  indi- 
cated which  are  cash  receipts  and  which  cash  pay- 
ments. The  only  journalization  necessary,  then,  is 
an  indication  of  what  account  is  to  be  credited  when 
Cash  is  debited,  and  what  account  is  to  be  debited 
when  Cash  is  credited.  The  journalization  is  now  so 
simple  that  we  have  only  to  make  a  statement  of  the 
origin  of  the  receipt  and  the  purpose  of  the  expendi- 
ture. In  order  to  avoid  the  possibility  of  abuse  of 
the  cash  book,  misrepresenting  the  amount  of  cash 
by  inserting  items  out  of  place,  it  is  desirable  to  use 
only  one  line  for  each  entry.  Then  there  will  be  an 
amount  carried  out  in  the  money  column  for  each 
line,  and  the  possibility  of  inserting  amounts  falsely 
for  the  purpose  of  manipulating  the  cash  balance  is 
removed.  Many  defaulters  have  taken  advantage 
of  loop-holes  left  in  carelessly  kept  cash  books  to 
make  insertions  which  covered  up  amounts  ab- 
stracted.   Only  when  entries  are  confined  to  one  line 


42 


ACCOUNTING  AND  AUDITING 


can  one  see  at  a  glance  that  nothing  is  perverted. 
The  f omi  of  a  double-entry  cash  book  is  shown  below. 
Since  receipts  are  always  written  on  left  pages,  as 
the  book  lies  open,  and  disbursements  on  right 
pages,  the  balance  on  hand  is  readily  shown  by  sub- 
traction of  totals. 

[Cash  Book] 

EECEIPTS. 


Jan. 


3 

John  Jones 

8 

Eichard  Hoe 

12 

Bills  Receivable 
Stationery 

15 

Peter  Smith 

22 

Bills  Payable 

28 

Freight 
Cash,  Dr. 

Jan. 


John  Doe 
Henry  Esmond 
Dombey  &  Son 
Bills  Payable 
Stalky  &  Co. 
Rent 

Commission 
Cash,  Cr. 


Bill  Dec.  26  paid 

On  account 

Note  of  Wm.  Brown  No.  14  Paid 

Envelopes 

Bill  Jan.  5  paid 

Borrowed  on  our  note  with  interest 

Fr  't  on  ship 't  to  Rice  &  Co.  repaid 


[Cash  Book] 
DISBURSEMENTS. 

Paid   his    bill    Dee.    26 

''       ''      ''     Jan.  1 

**     their  ''     Jan.  7 
Paid  our  note  of  Nov.  15 

''     their  bill  of  Jan.  11 
Rent  for  month  of  January 
On  sales  made  by  Samuel  Sanders 


540 

00 

.273 

50 

5000 

00 

5 

25 

1125 

00 

1000 

00 

12 

75 

1  7956150 

725 
370 
851 
1500 
110 
125 
41 


3723 


65 


The  purchase  booli  and  the  sales  book  are  com- 
monly similar  to  each  other  in  form.  The  only 
difference  between  them  is  that  the  purchase  book 
contains  credits  to  all  creditors  and  debits  to  IVCer- 
chandise,  whereas  the  sales  book  contains  debits  to 
all  customers  and  credits  to  Merchandise.  All  that 
is  necessary  in  the  way  of  a  record  for  each  transac- 
tion is  a  statement  of  the  creditor's  or  customer's 
name,  a  statement  of  the  terms  of  purchase,  and  a 
list  of  the  goods  with  the  amounts.  These  amounts 
are  carried  out  into  the  money  columns  with  all  dis- 
counts subtracted  before  the  final  extension,  and  at 


THE  METHOD  OF  ENTEY 


43 


the  end  of  the  week,  month,  or  other  desired  inter- 
val, the  total  is  taken  to  be  posted  to  Merchandise. 
The  precaution  that  no  discounts  shall  be  allowed 
to  get  into  the  extension  columns  is  important;  for, 
otherwise,  the  total  for  Merchandise,  which  is  the 
total  of  the  column,  would  include  not  only  the  net 
amount  of  the  bill,  but  the  amount  of  discount,  and 
sometimes  the  full  amount  of  the  bill  before  the  dis- 
count was  taken  off.  This  would  magnify  the  debit 
or  credit  to  Merchandise  and  throw  the  books  out 
of  balance  and  out  of  accord  with  the  truth.  A 
common  form  is  shown  below. 


John  Nicholson 


Peter  Ibbetson 


Thomas  Jones 


Merchandise,  Cr. 


[Sales  Book] 

Jan.  2. 

Terms  30  d. 

100  lbs.  Coffee 
40  lbs.  Tea 
50  lbs.  Flour 
20  lbs.  Chocolate 

330  lbs.  Sugar 


Discount  5% 


Terms  6%  10  d. 
5%  30  d. 
500  gal.  Molasses 
1500  lbs.  Sugar 


Terms  30  d. 
10  bbls.  Flour 
50  lbs.  Coffee 
200  lbs.  Tea 


25 

25 

00 

50 

20 

00 

00 

300 

00 

36 

7 

20 

05 

16 

50 

368 

70 

18 

43 

350 

27 

50 

250 

00 

/ 

04i 

67 

50 

317 

50 

00 

60 

00 

25 

12 

50 

50 

100 

00 

172 

50 

840 

27 

Two  purposes  are  to  be  served  in  making  entries 
in  books.  The  first  is  to  have  a  complete  record  of 
the  transaction  which,  in  any  matter  of  dispute,  may 
be  used  as  good  evidence  in  a  court  of  law;  the  second 
is,  as  has  been  suggested,  to  make  easy  the  arrange- 


44  ACCOUNTING  AND  AUDITING 

ment  of  items  in  the  ledger  so  that  they  shall  show 
the  balance  for  any  account.  We  have  been  con- 
cerned so  far  chiefly  with  the  second  of  these  pur- 
poses. It  remains  to  note  that  the  first  is  even  more 
important.  Many  bookkeepers  spend  a  good  deal  of 
time  in  trying  to  interpret  their  own  entries  because 
they  have  forgotten  the  circumstances  under  which 
the  entries  were  made,  and  have  left  their  record 
in  such  form  that  many  important  elements  in  the 
transaction  are  not  shown.  A  record  to  be  satisfac- 
tory should  show  about  every  transaction  absolutely 
every  detail  that  can  ever  be  a  matter  of  consequence 
to  know.  If,  for  instance,  a  transaction  is  a  sale  of 
goods  on  an  order,  the  entry  should  show  the  date  of 
the  sale,  the  date  of  the  order,  the  person  from  whom 
the  order  was  received,  the  number  of  the  order,  the 
amount  of  each  kind  of  goods  with  the  specific  name 
or  quality,  the  price  agreed  upon,  with  any  discounts 
that  may  have  been  offered,  and,  if  the  goods  are 
shipped  away,  an  indication  of  the  method  of  ship- 
ment,— such 'as  the  number  of  the  packing-case  or 
the  initials  and  number  and  destination  of  the  car, 
and,  if  the  goods  were  consigned  to  anyone  different 
from  the  customer  who  orders  them,  the  name  of 
such  consignee.  Similarly,  if  money  is  received  in 
payment  of  a  note,  the  entry  should  indicate  just 
what  note  it  is  meant  to  pay,  and,  if  the  notes  are  not 
listed  by  number  in  a  separate  book,  the  entry  should 
show  the  date  of  the  note,  the  maker,  the  endorsers, 
the  time,  the  amount,  and  the  interest,  if  any.  If 
the  entry  is  based  upon  any  calculation,  such  as  a 
percentage  of  discount,  it  is  advisable  to  indicate  the 
calculation  on  the  entry  itself  in  order  that  it  may 


THE  METHOD  OF  ENTRY  45 

bear  upon  its  face  evidence  of  its  own  correctness. 
Otherwise,  if  questions  ever  arise  as  to  the  correct- 
ness of  the  calculation,  all  must  be  done  over;  and  in 
the  end  it  is  cheaper  to  write  the  calculation  in  each 
entry  than  it  is  to  recalculate  the  many  entries  which 
commonly  require  examination. 

Errors  are  bound  to  occur  from  time  to  time,  and, 
therefore,  care  should  be  taken  that  the  corrections 
do  not  cast  suspicion  on  the  genuineness  of  the  rec- 
ord. A  posting  error  may  be  corrected  by  scratch- 
ing, for  since  the  ledger  is  not  a  book  of  original  entry 
and  is  legal  evidence  only  so  far  as  it  is  assumed  to 
be  a  proper  transcript  of  the  original  entry,  erasures 
are  not  serious.  We  should  not,  on  the  other  hand, 
ever  erase  a  figure  in  an  original  entry  unless  that 
figure  is  sufficiently  proved  by  its  context.  For  in- 
stance, if  we,  in  making  an  entry  crediting  a  per- 
sonal account  for  goods  purchased,  put  a  wrong  price 
and  then  scratch  not  only  the  price  but  the  extension 
of  the  amount  and  the  total  of  the  bill,  we  have 
opened  to  suspicion  the  whole  entry.  In  the  nature 
of  the  case,  there  can  be  no  evidence  that  the  change 
was  not  made  at  a  later  date  for  the  purpose  of  com- 
mitting fraud.  If,  on  the  other  hand,  the  error  is 
discovered  before  the  extension  has  been  made  and 
only  the  price  is  scratched,  the  fact  that  the  exten- 
sion is  unchanged  and  that  the  total  amount  of  the 
bill  is  unchanged  is  evidence  of  the  correctness  of 
the  price,  for  only  that  price  could  have  produced 
the  final  result.  Similarly,  even  though  we  have 
made  an  error  in  an  extension,  if  the  price  is  correct 
and  the  total  amount  of  the  bill  is  correct,  it  is  ob- 
vious that  the  scratching  of  the  extension  is  of  no 


46  ACCOUNTIKG  AND  AUDITING 

account;  for  if  the  other  items  in  that  bill  are  un- 
scratched,  a  subtraction  of  the  other  items  from  the 
total  proves  the  correctness  of  that  extension.  If, 
finally,  an  error  is  made  in  entering  the  total  of  the 
bill,  it  may  be  corrected  by  scratching,  because  if  the 
individual  items  of  the  bill  remain  unscratched  the 
total  is  vouched  for  by  simple  addition.  Usually 
when  a  change  must  be  made  it  is  wiser  to  leave  the 
original  figure  standing,  to  draw  a  line  through  it 
and  write  the  correct  figure  above,  than  to  erase  it 
entirely;  for  if  the  original  figure  standing  there  is 
obviously  incorrect  and  the  figure  above  is  the  only 
substitute  for  it,  we  see  at  a  glance  why  the  change 
was  made  and  accept  it  without  question.  If  the 
original  figure  had  been  erased,  however,  no  one 
could  tell  what  was  there  originally,  or  why  the 
change  was  made.  In  cases  where  it  is  impossible 
for  the  context  to  prove  the  correctness  of  the  figure 
put  in  after  an  erasure,  corrections  should  be  made 
not  by  any  erasure  but  by  a  new  or  counter  entry. 

Whatever  error  is  made  in  an  original  entry,  if 
only  the  debits  are  equal  to  the  credits,  a  proper 
counter  entry  will  correct  it.  If,  for  instance,  we 
credit  Cash  for  more  than  was  paid,  we  may,  by 
entering  the  amount  of  error  on  the  other  side  of 
the  cash  book  as  if  cash  was  received,  produce  the 
balance  of  truth.  If  we  charge  too  much  for  mer- 
chandise sold,  we  can  make  a  correcting  entry  h^ 
debiting  Merchandise  and  crediting  the  customei 
for  the  difference.  If  we  debit  too  much  to  Interest, 
consequently  crediting  Cash  too  much,  we  may  credit 
Interest  and  debit  Cash  for  the  amount'  of  error.  The 
method  of  making  such  corrections  is  usually  to  mark 


^HE  METHOD  OP  ENTRlf  47 

the  original  entry  very  plainly,  sometimes  in  red  ink 
— unless  one  objects  to  advertising  one's  errors  con- 
spicuously,— with  some  such  words  as  these:  '* Er- 
ror; for  correction  see  p.  27,  Jan.  10."  Then  in  the 
first  available  space  one  should  make  a  new  entry, 
debiting  and  crediting  the  proper  accounts  not  for 
the  original  corrected  figures,  but  for  the  amount 
of  alteration  necessary  to  produce,  with  the  original 
incorrect  entry,  the  true  result.  The  explanation 
should  be  somewhat  as  follows:  '*To  correct  error 
of  p.  17,  Dec.  21,  5c  per  yd.  overcharge  in  price,  to 
Andrew  Jackson."  When  this  new  entry  has  been 
posted,  the  balance  of  the  accounts  concerned  is  as  it 
should  be. 

Suppose,  for  instance,  we  have  credited  Bills  Re- 
ceivable when  we  should  have  credited  Bills  Payable. 
The  erroneous  entry  reads,  perhaps,  as  follows : 

Cash  1000 

To  Bills  Receivable  1000 

Since  the  Cash  is  correct  it  will  not  be  affected  by 
the  new  entry,  which  should  read  as  follows : 

Bills  Eeceivable  1000 

To  Bills  Payable  1000 

This  debit  to  Bills  Receivable  will  correct  the  er- 
roneous credit,  and  the  credit  to  Bills  Payable  will 
accomplish  what  should  have  been  done  in  the  first 
]»lace. 

The  substance  of  this  chapter  may  be  summar- 
ized briefly.  Entries  should  be  made  in  what  are 
called  books  of  original  entrj^  in  such  form  that  full 
information  about  every  transaction  is  shown  clearly. 


48  ACCOUNTING  AND  AUDITING 

and  the  arrangement  of  the  entry  should  be  such 
that  it  is  easy  to  transfer  the  desired  figures  from 
that  record  directly  to  the  ledger, — which  contains 
a  summary,  classified  by  accounts,  for  all  transac- 
tions. Original  entries  are  commonly  made  in  a 
cash  book  containing  only  cash  transactions,  a  pur- 
chase book  containing  only  purchases,  a  sales  book 
containing  only  sales,  and  a  journal  containing  every 
transaction  which  cannot  go  into  any  one  of  these 
three  other  books.  The  cash  book,  purchase  book, 
and  sales  book,  serve  not  only  as  a  convenient  means 
of  posting  cash  and  merchandise  in  totals  at  inter- 
vals, but  also  of  posting  proper  debits  and  credits 
to  the  other  accounts  concerned  in  the  transactions 
with  cash  and  merchandise;  that  is  to  say,  we  use 
the  cash  book,  for  instance,  not  only  for  debits  and 
credits  to  Cash,  but  for  credits  and  debits  to  the 
other  accounts  concerned  when  Cash  is  debited  and 
credited.  The  ledger,  on  the  other  hand,  is  not  a 
book  of  original  entry,  and  has  no  legal  value  except 
as  it  is  taken  to  represent  a  correct  transcription  of 
original  records,  and  its  only  function  is  to  bring 
together  the  items  relating  to  the  separate  accounts. 
No  erasures  should  be  made  in  any  figure  that  cannot 
be  easily  proved  clearly  correct  from  other  figures 
that  are  intact.  Any  necessary  changes  should  be 
thoroughly  explained. 


CHAPTER  IV 

THE  COMMON  LEDGER  ACCOUNTS 

We  have  so  far  noted  the  distinction  between 
debit  and  credit,  and  the  simple  forms  of  entry. 
Quite  as  important  as  proper  debiting  and  crediting, 
however,  is  proper  choice  of  the  account  to  which  a 
debit  or  a  credit  shall  be  made.  We  have  seen  that 
accounts  are  of  three  classes — with  persons,  with 
property,  and  with  forces.  It  is  obvious  that  if  we 
make  the  error  of  debiting  to  a  force,  which  can 
never  repay,  an  amount  that  ought  to  be  debited  to 
an  individual,  who  must  repay,  our  books  are  mis- 
leading. If,  again,  we  debit  to  a  property  account, 
as  if  the  value  were  on  hand,  what  ought  to  have  been 
debited  to  a  force  account,  as  an  explanation  of  loss, 
we  are  overstating  our  possessions.  If,  again,  we 
credit  one  force  account  when  we  ought  to  credit 
another,  we  may  mislead;  if,  for  instance,  we  credit 
Interest — when  he  ought  to  credit  Insurance — for 
an  amount  allowed  on  the  cancellation  of  an  insur- 
ance policy,  though  we  have  not  misstated  the 
amount  of  our  property  we  have  misstated  the  source 
from  which  some  of  our  property  has  come;  that  is, 
we  have  made  the  record  indicate  that  we  have 
earned  as  a  clear  profit  a  sum  which  in  reality  was 
merely  a  repa}niient  of  an  insurance  premium  vainly 

A  &  A-4  49 


so  ACCOUNTING  AND  AUDITING 

paid.  Such  an  error  misrepresents  to  us  not  only  our 
actual  earnings  by  lending  money,  but  also  the  ex- 
pense of  insurance;  and  if  we  are  to  use  our  figures 
in  drawing  conclusions  as  to  the  subsequent  conduct 
of  our  business,  we  shall  be  misled  unless  the  item 
is  small.  This  matter  of  deciding  to  what  ledger 
account  each  item  shall  be  carried,  therefore,  is  of 
great  importance. 

It  is  worth  while  to  examine  with  considerable 
care  the  commonest  of  the  ledger  accounts  and  de- 
termine just  what  each  should  represent.  It  is  to 
be  noted,  however,  that  the  important  matter  is  not 
that  any  hard  and  fast  rules  shall  be  followed,  but 
only  that  the  bookkeeper  himself  shall  know  what 
the  account  on  his  own  ledger  means  in  the  case  of 
his  own  business.  Names  are  of  no  consequence 
anywhere  if  only  the  people  who  use  the  names 
always  know  exactly  what  is  meant  by  the  name 
used.  It  would  matter  not  at  all,  for  instance,  if  all 
English-speaking  people  were  to  agree  that  what 
previously  has  been  called  an  *^ apple''  should  here- 
after be  called  a  ^Hable,"  and  that  what  previously 
had  been  called  a  *Hable"  should  hereafter  be  called 
an  *' apple."  To  read,  then,  that  a  man  ate  a  table 
and  wrote  at  an  apple  would  confuse  no  one,  and  a 
man  indeed  may  in  his  own  memoranda  kept  for  pri- 
vate purposes  transpose  these  two  terms  with  per- 
fect freedom  and  without  danger  of  confusion  if  he 
only  remembers  exactly  what  he  means  by  each.  So 
in  bookkeeping  the  title  of  an  account  is  of  no  conse- 
quence if  only  those  who  are  to  use  it  know  what  use 
is  made  of  it  under  that  title;  but  since  accounts  are 
commonly  read  by  others  than  the  makers,  it  is  wise 


I'HE  COMMON  LEDGER  ACCOUNTS       5l 

to  follow  common  practice  lest  there  be  misunder- 
standings. Above  all  else,  since  accounts  are  likely 
to  be  called  into  court,  unusual  uses  of  terms  may  lay 
one  open  to  suspicion  of  attempt  at  fraud,  and  should 
be  avoided. 

The  most  obvious  account  with  which  all  business 
is  concerned  is  Cash.  (Hereafter,  when  a  common 
noun,  like  ^^cash,''  is  used  with  a  capital  letter,  it 
will  be  understood  that  the  name  indicates  not  the 
thing  itself  but  the  name  of  the  ledger  account  which 
is  to  represent  it.)  To  Cash  is  usually  carried  not 
only  actual  money  in  hand,  such  as  silver,  gold,  and 
legal  paper  money,  but  also  checks  and  money  orders. 
Checks  and  money  orders  are  included  because  they 
are  supposed  to  be  convertible  at  sight  into  the  actual 
legal  money;  and,  therefore,  it  is  not  worth  while  to 
distinguish  on  the  books  between  them  and  currency. 
As  a  matter  of  fact  checks  are  not  usually  turned 
into  cash  but  are  deposited  in  banks,  where  they  go 
to  swell  the  cash  balance  without  any  handling  of 
specie  and  bills.  Bank  balances,  also,  are  usually 
considered  as  cash  because  bills  can  be  paid  with 
them  as  readily — usually  more  readily — than  with 
the  actual  money;  and  although  some  business  houses 
keep  a  separate  account  for  bank  balances,  most 
houses  make  no  such  distinction.  When  it  is  desired 
to  make  such  distinction,  it  is  easy  to  provide  a 
special  column  in  the  cash  book  for  bank  balances  as 
distinguished  from  legal  money.  Two  items  which 
might  readily  be  confused  with  cash  but  should  not 
appear  on  the  cash  account  are  promissory  notes  and 
drafts.  These  are  only  orders  or  promises  to  pay, 
and  cannot  in  any  proper  sense  be  deemed  cash  until 


52  ACCOUNTING  AND  AUDITING 

the  pajonent  has  actually  been  made.  It  is  true  in 
a  sense  that  a  bank  check  is  only  an  order  to  pay, 
but  since  the  order  is  on  a  bank  whose  business  it  is 
to  make  payments  on  the  orders  of  its  depositors, 
the  normal  condition  is  one  in  which  the  check  is  as 
good  as  money  and  is  as  readily  used  in  making  pay- 
ments. '  The  courts,  moreover,  have  given  checks 
special  protection  so  that  they  may  be  considered 
money,  and  a  man  who  issues  a  check  without  money 
behind  it  is  guilty  of  obtaining  money  under  false 
pretenses,  which  is  an  offence  with  a  very  heavy  pen- 
alty attached.  Inability  or  i^nwillingness  to  pay 
notes  or  drafts,  on  the  other  hand,  is  not  legally  an 
offence:  the  only  penalty  is  a  loss  of  credit;  and, 
therefore,  such  evidences  of  debt  are  nothing  more 
than  claims  similar  in  nature  to  debts  due  where  no 
document  has  been  given. 

The  account  representing  promissory  notes  is 
Bills  Eeceivable.  This  account  does  not  include 
claims,  against  customers  or  others,  unless  evidence 
has  been  given  in  the  form  of  written  promises  to 
pay  money  when  due.  Of  course,  if  money  is  owed 
to  a  business  by  a  customer,  the  books  must  some- 
where show  the  debit  to  that  customer,  and  such  a 
debit  to  him  indicates  that  he  has  not  made  payment; 
but  if  he  has  given  written  promise  to  pay,  in  the 
form  of  a  promissory  note,  he  has  made  payment  of 
the  original  debt.  He  has  given  the  business  an 
equivalent  for  the  goods  purchased,  and  the  business 
will  collect  from  him,  if  he  is  solvent,  not  for  the 
goods  but  for  the  note.  If  collection  must  be  made 
through  the  courts,  the  business  holding  the  note 
does  not  have  to  show  just  what  is  the  origin  of  the 


THE  COMMON  LEDGEE  ACCOUNTS  53 

obligation,  but  must  sue  on  the  note,  for  the  note  is 
itself  evidence  that  the  obligation  exists — but  it  is  at 
the  same  time  evidence  that  the  original  debt  no 
longer  exists.  In  other  words,  the  note  is  itself  prop- 
erty which  has  paid  for  the  merchandise.  The  busi- 
ness, then,  has  no  longer  any  claim  against  its  cus- 
tomer for  the  goods  sold  him,  and  must  not  have  any 
debit  against  him  on  its  books.  So  Bills  Receivable 
represents  property  as  distinguished  from  claims; 
and  this  is  true  in  part  because  promissory  notes  may 
be  bought  and  sold  and  transferred  from  hand  to 
hand  just  as  can  merchandise  or  cash.  The  purpose 
in  maintaining  an  account  on  the  ledger  with  such 
notes  is  to  show  exactly  how  much  of  this  kind  of 
property — ^promises  as  distinguished  from  money, 
and  property  as  distinguished  from  claims — is  in  the 
possession  of  the  business. 

To  this  account  are  carried  also  drafts  after  they 
have  been  accepted  by  those  upon  whom  they  were 
drawn.  The  common  transaction  for  a  draft  is  that 
in  which  a  man  to  whom  money  is  owed  draws  a 
paper  ordering  the  man  who  owes  him  to  pay,  usually 
to  a  third  person,  the  sum  of  money  owed.  The  per- 
son who  is  ordered  to  pay  is  under  no  legal  obligation 
to  make  payment  in  this  way  unless  he  chooses.  If 
he  is  willing  to  pay,  he  indicates  his  willingness  by 
writing  the  word  ^^ accepted"  and  signing  his  name 
across  the  face  of  the  draft.  Until  he  has  done  this, 
the  order  to  pay  is  nothing  but  worthless  paper, — 
unless,  indeed,  it  is  what  is  called  a  sight  draft  de- 
manding immediate  payment,  and  even  then,  of 
course,  the  person  ordered  to  pay  is  under  no  obliga- 
tion to  make  payment  in  this  form  unless  he  is  so 


64  ACCOUNTING  AND  AUDITING 

inclined.  It  is  not  customary,  therefore,  to  make 
any  entry  on  books,  except  by  way  of  memorandum, 
when  a  draft  is  drawn  ordering  somebody  to  pay  to 
a  third  person  for  the  benefit  of  the  business.  As 
soon  as  such  a  draft  is  accepted,  however,  the  drawee, 
or  person  ordered  to  pay,  has  given  his  written 
promise  to  make  payment  in  due  season,  and  this  is 
exactly  identical  in  nature  with  a  promissory  note 
which  he  might  have  drawn  in  the  ordinary  form. 
Since,  then,  there  is  no  distinction  in  nature  between 
an  accepted  draft  and  a  promissory  note,  such  drafts 
are  always  included  with  the  notes  as  making  up  the 
body  of  Bills  Eeceivable. 

Bills  Receivable  should  be  debited  for  only  the 
face  of  notes  and  drafts  held.  This  account  should 
represent  property  and  ought,  theoretically,  to  re- 
main unchanged  for  any  one  note  so  long  as  that 
note  is  unpaid.  When  a  note  bears  interest,  how- 
ever, the  claim  which  the  holder  of  the  note  has 
against  the  signer  is  not  m^rely  for  what  is  called  the 
face  of  the  note-— that  is,  the  amount  written  in  as 
dollars  and  cents — ^but  also  for  an  additional  sum, 
or  interest,  which  is  a  certain  percentage  of  the  face 
value.  It  would  be  possible  to  let  Bills  Receivable 
represent  not  only  the  face  of  such  notes  but  also  the 
amount  of  accrued  interest.  To  do  so,  however, 
would  mean  that  if  we  wished  Bills  Receivable  to 
represent  the  true  value  of  notes  at  all  times,  we 
should  be  obliged  every  day  to  figure  interest  on  all 
interest-bearing  notes  that  we  held  and  add  that  as  a 
debit  to  Bills  Receivable.  This  would  involve  a  large 
amount  of  labor  in  businesses  handling  many  notes. 
A  simpler  method  is  to  debit  Bills  Receivable  for 


THE  COMMON  LEDGER  ACCOUNTS  55 

only  the  face  value  of  notes,  and  to  make  record  of 
the  interest  only  at  the  time  that  interest  is  involved 
in  some  transaction, — or  whenever  the  books  are 
used  in  figuring  profits  at  the  end  of  an  earning 
period,  as  at  the  end  of  the  fiscal  year.  So  far  as 
the  books  are  concerned,  then,  in  this  matter  of  Bills 
Receivable  there  would  appear  no  difference  between 
a  case  in  which  a  note  was  received  bearing  interest 
and  payable  in  six  months,  and  one  in  which  a  note 
had  been  held  for  three  months  without  bearing  in- 
terest, even  though  the  note  had  been  made  three 
months  before  the  time  it  came  into  the  hands  of 
this  business.  To  summarize  Bills  Receivable,  then, 
we  may  say  that  the  balance  of  this  account  repre- 
sents simply  the  face  value  of  written  promises  held 
by  the  business,  either  so-called  promissory  notes  or 
accepted  drafts. 

In  this  connection,  before  we  pass  on  to  Bills 
Payable,  which  is  the  converse  of  Bills  Receivable, 
it  is  well  to  note  the  relation  of  Interest  to  Bills  Re- 
ceivable. Many  persons  unfamiliar  with  business 
find  difficulty  in  realizing  what  is  the  actual  value  of 
a  note,  assuming  the  maker  of  the  note  to  be  solvent, 
as  distinguished  from  its  face  value.  One  thing  is 
necessary  to  understand  at  the  start,  viz.,  that  a  note 
is  a  promise  to  pay  a  definite  sum  of  money,  neither 
more  nor  less,  and  at  a  definite  time.  If  the  note 
reads,  '^Two  months  from  date  I  promise  to  pay  to 
John  Doe  $5,000,"  it  is  a  claim  enforceable  two 
months  from  date  for  $5,000  and  for  no  more.  If  the 
maker  of  the  note  had  promised  to  pay  $5,000  and 
interest,  the  note  would  have  read  **  $5,000  and  inter- 
est."   Without  a  direct  stipulation  that  interest  is 


66  ACCOUNTING  AND  AUDITING 

to  be  added  on  the  expiration  of  the  time  named,  no 
interest  can  be  demanded.  Yet  it  is  a  commonplace 
of  business  experien(ie  that  one  cannot  use  other 
people's  money  without  paying  for  it  in  one  form  or 
another.  If,  then,  the  maker  of  a  note  has  not  prom- 
ised to  pay  interest,  the  note  is  not  until  the  day  of 
maturity  worth  the  amount  written  on  its  face.  A 
note  payable  two  months  in  the  future  is  one  requir- 
ing the  owner  to  wait  two  months  for  payment.  No 
one  in  a  business  transaction  would  accept  such  a 
$5,000  note  as  a  $5,000  payment.  Such  a  note  would 
be  accepted,  when  interest  is  at  six  per  cent.,  for  only 
$4,950,  for  the  discount  is  $50  for  two  months.  Under 
one  condition,  however,  it  would  be  taken  at  face 
value, — i.  e.,  in  case  the  $5,000  payment  itself  is  not 
due  for  two  months.  If,  for  instance,  I  have  bought 
goods  in  a  trade  where  it  is  customary  to  allow  pur- 
chasers two  months  in  which  to  make  payments,  and 
I  pay  for  those  goods  with  a  note  payable  in  two 
months,  I  am  making  proper  payment;  for  the  money 
named  in  the  note  becomes  due  on  the  day  when  I 
should  pay  for  the  goods.  Even  here,  however,  if 
the  firm  receiving  that  note  from  me  in  payment  of 
their  goods  now  wishes  to  make  use  of  that  note  in 
its  business — if,  for  instance,  it  wishes  to  borrow 
money  on  that  note  from  a  bank, — it  cannot  expect 
to  sell  the  note  for  $5,000,  for  whoever  lends  the 
money  will  be  forced  to  wait  two  months  for  its  pay- 
ment and  then  he  can  collect  not  $5,000  with  interest, 
but  only  $5,000  straight.  The  value  of  that  note 
today,  then,  is  not  $5,000,  but  only  $5,000  less  dis- 
count, and  the  discount  is  equivalent  to  the  interest 


THE  COMMON  LEDGEE  ACCOUNTS  57 

for  two  months.*  If  now  we  take  the  case  of  a  note 
bearing  interest,  we  shall  find  the  circumstances  very 
different.  Suppose  I  buy  goods  in  a  trade  in  which 
payment  is  expected  at  once.  If  it  is  inconvenient 
for  me  to  make  such  cash  payment  and  my  credit  is 
good,  I  can  probably  persuade  those  from  whom  I 
buy  to  accept  my  note  promising  to  pay  the  $5,000  in 
two  months,  provided  I  make  the  note  to  read  ^*with 
interest."  They  will  then  have  a  claim  against  me 
at  the  end  of  that  time  not  only  for  the  original 
$5,000,  which  I  should  normally  have  paid  at  the  time 
of  purchase,  but  for  compensation  in  the  nature  of 
interest  for  the  delay  which  they  have  suffered  in 
making  the  collection.  If  they  do  not  wish  to  wait, 
before  using  the  money,  until  the  two  months  have 
expired,  they  can  sell  that  note  to  someone  else  who 
will  pay  for  it  in  cash;  and  the  value  of  that  note  to 
the  purchaser  will  be  not  only  the  full  face  value 
written  on  the  note  on  the  day  of  issue,  but  more  to 
the  extent  of  the  interest  for  each  day  by  which  its 
maturity  or  date  of  payment  has  approached.  This 
difference  between  notes  bearing  interest  and  notes 
not  bearing  interest  may  well  be  indicated  by  parallel 
columns  showing  for  five  dates  the  values  of  each. 
It  will  be  seen  there  that  both  are  increasing  in 
value, — one  approaching  its  face  value  because  the 


*  In  practice  the  discount  would  be  $50,  or  1  per  cent  of  the  face  of 
the  note.  This  is  called  "bank  discount."  In  theory,  the  amount  of 
discount  is  not  the  interest  of  $5,000  for  two  months,  but  something 
less  than  that,  for  not  $5,000  is  lent.  True,  or  theoretical,  discount  is 
used  in  valuing  bonds,  leases,  insurance  premiums,  etc.  The  method 
is  to  divide  the  face  of  the  obligation  by  the  sum  which  one  dollar  will 
amount  to  at  interest  for  the  required  time.  This  quotient  will  show 
how  many  dollars  will  be  required  to  produce  the  face  of  the  obligation. 
If,  here,  we  divide  $5,000  by  1.01,  we  get  $4,950.49%.  If  this  were  put 
at  interest,  it  would  amount  to  just  $5,000  at  'the  end  of  two  months. 


88  ACCOUNTING  AND  AUDITING 

time  of  payment  of  the  specified  amount  is  approach- 
ing, the  other  exceeding  its  face  value  because  it  will 
ultimately  call  for  an  amount  in  excess  of  the  face 
value  by  the  interest  for  the  time  elapsed.  We  will 
assume  both  notes  to  be  for  $5,000,  payable  in  four 
months,  dated  January  1,  when  interest  is  6  per  cent. 

Not  bearing  interest    Bearing  interest 

Jan.  1  $4,900.00  $5,000.00 

Feb.  1  4,925.00  5,025.00 

March  1  4,950.00  5,050.00 

April  1  4,975.00  5,075.00 

May  1  5,000.00  5,100.00 

A  note  bearing  interest  will  not  usually  specify 
the  rate  unless  no  legal  rate  happens  to  be  estab- 
lished in  that  locality  or  unless  it  is  to  bear  a  rate 
different  from  the  legal.  The  discount  rate,  for  a 
note  not  bearing  interest,  is  a  matter  of  custom;  but 
it  is  never  specified  in  the  note  itself,  for  such  a  note 
has  no  concern  with  discount — it  is  a  promise  to  pay 
a  fixed  sum,  and  that  sum  only,  at  a  fixed  date,  and 
its  discounted  value  is  a  matter  for  agreement  be- 
tween buyer  and  seller  only.  The  deduction  from  the 
face  value  of  a  note  is  called  discount,  and  the  addi- 
tion to  the  value  of  a  note  is  called  interest;  but  in 
nature  the  two  are  identical.  Discount  is  taken  out 
at  the  start  as  a  decrease  in  value  below  face  value ; 
interest  is  added  at  the  end  as  an  increase  in  value. 
The  discussion  of  the  treatment  of  interest  on  the 
hooks  had  best  be  postponed  until  we  come  to  con- 
sider so-called  force  or  nominal  accounts. 

Just  as  Bills  Eeceivable  is  treated  so  as  to  repre- 
sent only  written  promises  owned  by  the  business 
on  whose  book^  they  appear,  Bills  Paj^able  should, 


THE  COMMON  LEDGER  ACCOUNTS       59 

represent  only  written  promises  issued  by  the  firm 
on  whose  books  they  appear;  so  that  John  Jones's 
Bills  Receivable  may  be  identical  with  John  Smith's 
Bills  Payable,  and  the  same  note  is  to  one  a  bill  re- 
ceivable and  to  the  other  a  bill  payable.  Bills  Pay- 
able, like  Bills  Receivable,  moreover,  does  not  in- 
clude claims  for  debt  unless  a  definite  written  prom- 
ise to  pay  has  been  given,  and  it  includes  accepted 
drafts, — in  this  case,  drafts  accepted  by  the  firm  and 
ordering  it  to  pay  to  others. 

Most  of  the  other  property  accounts  are  of  a  na- 
ture so  simple  that  seldom  question  arises  as  to  a 
choice  of  titles.  To  Real  Estate,  for  instance,  would 
be  charged  purchases  of  land  and  buildings.  To 
Machinery  and  Plant  would  be  charged  expenditures 
for  purchases  of  equipment  for  manufacturing.  To 
Furniture  and  Fixtures  would  usually  be  charged  the 
equipment  for  an  office  or  a  store.  Akin  to  these, 
though  having  some  elements  usually  different  from 
them,  is  Merchandise,  which,  as  ordinarily  kept,  has 
peculiarities  which  it  wilkbe  well  to  discuss  only  after 
we  have  given  some  attention  to  nominal  accounts. 

The  most  obvious  account  representing  what  we 
have  called  explanation,  or  nominal,  accounts,  is 
Wages.  This  represents  the  obvious  fact  that  we  can- 
not expect  other  men  to  work  for  us  without  compen- 
sation, and  the  debit  to  that  account  indicates  for  how 
much  of  our  outgo  that  force  in  human  nature  is  re- 
sponsible. This  account  may  be  divided  into  sev- 
eral portions — for  instance,  one  subdivision  may  be 
for  salaries  of  managers,  as  distinguished  from  the 
wages  of  day  laborers, — but  in  nature  the  itema  are 
similar.    It  is  difficult  to  conceive  of  Wages  as  any- 


60  ACCOUNTING  AND  AUDITING 

thing  but  purely  nominal,  for  at  best  it  explains  why 
a  shrinkage  has  occurred  in  assets.  It  is  true,  of 
course,  that  return  is  expected  for  the  wages  ex- 
pended, but  that  return  does  not  come  back  into 
Wages  unless  one  is  engaged  in  the  nefarious  busi- 
ness of  hiring  people  and  then  letting  them  out  to 
someone  else  at  a  higher  price;  in  all  other  cases  the 
return  for  wages  paid  appears  not  in  Wages  but  in 
a  credit  to  some  other  account  representing  the  in- 
crease in  the  value  of  property,  such  as  Merchandise, 
or  Real  Estate. 

Similar  to  Wages  as  nominal  accounts  indicating 
expense  are  Printing,  Postage,  Insurance,  Taxes,  etc., 
all  of  which  might  be,  in  a  business  attempting  only 
very  simple  accounting,  charged  to  one  general  ac- 
count which  might  be  called  '^Expense."  As  soon  as 
a  business  has  passed  beyond  a  very  simple  state,  one 
linds  usually  that  these  various  elements  of  expense 
may  be  profitably  distinguished  in  separate  accounts* 

Nominal  accounts  are  of  value  quite  as  mu(5h  in 
distinguishing  sources  of  profit  as  in  measuring  the 
force  of  causes  of  loss.  For  instance,  if  we  are  com- 
mission merchants  engaged  in  the  selling  of  goods 
for  others,  the  commissions  which  we  collect  would 
naturally  be  credited  to  an  account  representing  that 
department  of  our  activity.  Items  of  that  sort  would 
be  carried  to  Commission, — though  for  a  firm  which 
employed  agents  to  sell  its  goods  that  same  title 
would  be  used  for  an  account  which  represented  an 
expense  of  selling.  Similar  to  Commission  in  this 
respect  would  be  Rent  for  a  firm  renting  property, 
but  Rent  on  the  books  of  a  firm  hiring  property  would 


THE  COMMON  LEDGER  ACCOUNTS  6t 

be  an  expense  account.    Nominal  accounts,  then,  may 
represent  either  gains  or  losses. 

A  nominal  account  which  may  have  a  balance  first 
on  one  side  and  then  on  the  other  is  Interest.  Al- 
though it  is  true  that  any  one  firm  is  likely  to  be 
usually  either  a  borrower  or  a  lender,  every  firm  is 
likely  to  have  interest  items  upon  both  sides  of  the 
account  merely  in  the  handling  of  notes  and  drafts. 
For  instance,  in  the  case  used  as  an  illustration  on 
page  56,  the  firm  accepting  a  promissory  note  must 
debit  Bills  Eeceivable  for  the  full  face  of  that  note, 
or  $5,000.  If  the  note  does  not  bear  interest,  how- 
ever, and  the  firm  sells  that  note  to  somebody  else 
a  month  later,  it  will  get  not  $5,000,  but  consid- 
erably less,  possibly  $4,975.  That  is  to  say,  since 
the  other  firm  taking  the  note  must  wait  a  month 
before  the  $5,000  called  for  by  the  note  can  be  col- 
lected, it  will  subtract  from  the  face  of  the  note 
enough  to  compensate  it  for  accepting  the  note  so  far 
in  advance  of  the  time  when  it  shall  be  paid.  This 
other  firm  will  take  out  interest  for  one  month,  or 
$25.  The  firm  which  originally  received  this  note 
from  its  customer  has  already  debited  Bills  Receiv- 
able $5,000  and  has  credited  the  customer  $5,000. 
On  having  the  note  discounted,  however,  it  must 
credit  Bills  Receivable  $5,000,  for  that  department  of 
the  business  has  surrendered  the  note  charged  to  it 
at  $5,000,  and  it  will  debit  Cash  $4,975  and  Interest 
$25  (which  explains  or  holds  Interest  responsible  for 
the  loss  of  $25).  This  was  a  case  in  which  though 
no  interest  was  actually  specified  or  paid  as  such,  the 
Interest  entry  had  to  be  made.  The  second  firm  ac- 
cepting this  note  will  be  allowing  $4,975  for  a  note 


6^  ACCOUNTING  AND  AIJDITINa 

of  which  the  face  value  is  $5,000,  and  $5,000  will  he 
received  by  it  at  the  time  the  note  becomes  due.  The 
entry  on  its  books  when  it  accepts  the  note,  there- 
fore, will  be  to  debit  Bills  Receivable  $5,000,  to  credit 
Cash  (if  they  paid  cash)  $4,975,  and  to  credit  Interest 
$25.  That  is  to  say,  though  the  note  is  worth  on  its 
face  value  $5,000,  the  firm  allows  to  the  others  from 
whom  it  takes  the  note  only  the  actual  value  of^ 
$4,975,  and  pays  accordingly.  The  difference  be- 
tween the  face  value  and  the  amount  which  it  allows 
for  the  note  is  a  profit  due  to  the  fact  that  it  is  will- 
ing to  wait  one  month  for  payment,  and  this  profit  is 
properly  recorded  under  the  head  of  Interest  because 
the  force  which  Interest  represents  has  brought  in 
that  gain.  If  the  note  bears  interest,  on  the  other 
hand,  when  that  interest  is  collected  Interest  must 
be  credited. 

Recognizing  the  fact  that  Interest  is  debited  for 
all  losses  on  account  of  interest  and  credited  for  all 
gains  on  account  of  interest,  the  only  complication 
arises  in  determining  in  each  case  whether  the  inter- 
est should  be  entered  now  or  only  at  a  later  date. 
Of  course  in  the  case  last  worked  out  the  profit  is  not 
really  made  until  the  note  is  paid;  that  is,  $4,975  was 
allowed  for  the  note,  we  will  say,  on  December  1,  but 
the  $5,000  was  not  collected  until  January  1.  In  one 
sense,  therefore,  it  is  true  that  the  profit  should  be 
entered  only  on  January  1;  but  in  the  meantime  the 
books  would  be  failing  to  show  the  fact  that  there 
was  a  $25  discrepancy  between  the  face  value  of  the^ 
note  recorded  in  the  Bills  Receivable  account  and  the 
$4,975  paid  in  cash;  and  such  discrepancies  are  not  to 
be  allowed* upon  the  books.    Indeed,  the  purpose  of 


THE  COMMON-  LEDGER  ACCOUNTS  63 

double  entry  is  to  explain  always  day  by  day  the 
origin  of  any  figures  of  profit  and  loss.  Although  it 
is  true,  therefore,  that  the  interest  is  not  properly 
gained  until  January  1,  yet  since  the  transaction  in 
all  its  outward  forms  is  really  complete  on  December 
1,  in  the  sense  that  the  promise  to  pay  the  extra  $25 
was  received  in  the  form  of  the  note  on  December  1, 
that  is  the  desirable  time  to  make  the  entry;  for  so 
far  as  the  books  are  concerned  it  is  the  promise  rather 
than  the  performance  which  determines  the  amount 
of  money  to  be  entered  on  the  books.  When,  on  the 
other  hand,  the  note  bears  interest,  it  is  true  that  the 
promise  to  pay  interest  is  made  on  the  earlier  date, 
just  as  it  is  in  the  last  case  discussed,  but  the  promise 
is  not  expressed  in  terms  of  dollars  and  cents.  The 
note  reads,  **I  promise  to  pay  $5,000  with  interest;" 
but  as  the  amount  of  interest  is  not  entered  on  the 
face  of  the  note  and  is  not  properly  to  be  included 
in  Bills  Eeceivable,  it  is  not  yet  to  be  credited  to 
Interest,  and  that  portion  of  the  interest  remains  off 
the  books  until  actually  paid.  In  other  words,  the 
entry  to  Interest  is  made  at  the  time  that  the  trans- 
action takes  a  definite  form  in  dollars  and  cents,  and 
is  entered  on  the  books  as  such  whether  the  payment 
is  made  at  that  time  or  later.  As  will  be  shown  in 
another  connection,  this  method  does  not  cause  the 
books  to  misrepresent  facts  with  regard  to  Interest; 
for,  in  any  proper  plan  of  accounting,  whenever  the 
books  are  closed  or  the  profit  and  loss  for  the  year  is 
determined,  allowances  are  made  for  all  accrued 
items  which  have  not  yet  been  entered  upon  the 
books. 


64  ACCOUNTING  AND  AUDITING 

We  have  now  discussed  property  or  real  accounts 
and  force  or  nominal  accounts.  We  have  remaining 
one  account  which,  as  commonly  kept,  is  both  real 
and  nominal.  The  suggestion  was  made  in  the  sec- 
ond chapter  that  if  we  debit  Merchandise  for  all  pur- 
chases at  cost  and  credit  Merchandise  for  all  sales 
at  selling  price,  the  balance  between  them  will  not 
represent  goods  on  hand,  for  the  debits  and  credits 
were  not  at  the  same  prices,  but  will  include  a  cer- 
tain amount  of  profits — ^if  profits  have  been  made. 
How  much  profit  will  be  included  in  such  a  balance 
must  be  determined  by  figures  not  included  in  the 
account  itself.  Under  this  plan  of  keeping  Mer- 
chandise account,  therefore,  we  are  not  getting  quite 
the  results  we  usually  expect  to  get  from  either  prop- 
erty accounts  or  force  accounts,  for  the  balance  is 
neither  straight  property  nor  straight  profits.  We 
can  determine  the  profit,  however,  by  taking  account 
of  stock  and  relating  the  valuation  to  the  purchases 
and  the  sales.  The  method  of  doing  this  will  be 
described  later  in  this  chapter. 

Before  going  further  in  our  discussion  of  the  use 
of  particular  accounts  it  is  worth  while  to  pause  to 
work  out  a  number  of  practical  cases  and  see  how 
the  various  accounts  are  to  be  debited  and  credited. 
Then,  with  a  better  notion  of  just  how  each  account 
looks  and  what  it  stands  for,  we  may  analyze  it  fur- 
ther and  see  its  real  significance.  Let  us  assume  a 
business  buying  and  selling  merchandise,  receiving 
and  giving  notes,  paying  and  collecting  bills,  and  in- 
dicate for  it  the  commonest  transactions  and  the 
ways  by  which  those  transactions  would  get  upon  its 
books  of  account.    The  most  profitable  way  of  doing 


THE  COMMON"  LEDGEB,  ACCOUNTS  65 

this  for  the  present  is  to  assume  that  all  items  go 
upon  the  journal,  and  not  to  attempt  at  this  time 
to  distinguish  in  use  between  journal,  cash  book, 
sales  book,  and  purchase  book.  We  shall  thus  have 
all  parts  of  each  transaction  before  us  at  once.  After 
we  have  once  made  these  entries  in  journal  form,  we 
may  then  split  them  among  the  separate  books  and 
show  how  they  w^ould  appear  upon  a  ledger. 

Let  us  suppose  that  Laurence  Sterne  begins  busi- 
ness January  1  w^ith  the  following  capital:  cash, 
$15,000;  store  building,  $15,000;  a  promissory  note  of 
George  Eliot,  for  $1,000,  dated  January  1,  payable 
in  two  months;  a  promissory  note  of  George  Evans, 
for  $2,000,  dated  December  1,  payable  in  two  months; 
a  promissory  note  of  George  H.  Lewes,  for  $500, 
dated  December  16,  payable  in  one  month;  a  prom- 
issory note  of  George  Meredith,  for  $1,500,  dated  No- 
vember 1,  payable  on  demand  with  interest.  For 
this  opening  of  business  an  entry  would  need  to  be 
made  so  as  to  provide  debits  and  credits  to  several 
accounts.  In  the  first  place,  we  must  realize  that  the 
proprietor  is,  for  the  books  of  the  business,  an  out- 
sider. The  books  are  not  his  books,  except  as  he 
chances  to  own  the  business.  On  them  he  will  be 
credited  for  what  he  puts  in  and  debited  for  what  he 
takes  out — just  as  anyone  else  would  be  debited  and 
credited. 

Cash  would  Ibe  debited  because  the  cash  drawer  or 
the  cashier  is  responsible.  Real  Estate  would  bq 
debited  because  that  department  of  the  business,  or 
the  property  itself,  if  one  prefers  to  put  it  that  way, 
is  responsible  for  that  amount  of  value.  Bills  Re- 
ceivable would  be  debited  for  $5,000,  because  the 

A  &  A-5 


ee  ACCOUNTING  AND  AUDITING 

total  face  value  of  these  notes  amounts  to  that  sum, 
and  the  bills  receivable  account  should  represent 
face  values  only.  The  proprietor,  Laurence  Sterne, 
however,  cannot  be  credited  properly  with  the  full 
face  of  the  notes,  for  although  these  notes  will  bring 
in  a  total  of  $5,000,  and,  indeed,  more,  since  the  last 
of  them  bears  interest,  he  is  not  turning  over  to  the 
business  property  worth  $5,000  on  the  day  that  the 
business  is  opened:  the  business  must  wait  two 
months  to  collect  the  $1,000  ultimately  due  on  the 
first  note ;  it  must  wait  one  month  to  collect  the  $2,000 
on  the  second  note;  it  must  wait  fifteen  days  to  col- 
lect the  $500  due  on  the  third  note.  Obviously,  if  a 
man  is  going  to  debit  his  business  or  the  business  is 
going  to  credit  him  with  an  investment,  the  facts  are 
stated  properly  only  when  he  is  credited  on  the  books 
of  the  business  for  the  amount  invested  on  the  day 
of  investment.  When  the  year  is  over,  an  attempt 
will  be  made  from  the  books  to  determine  just  what 
the  business  has  earned  from  each  one  of  its  sources 
of  income,  including  interest,  and  just  what  it  has 
lost  from  each  one  of  its  causes  of  expense.  Clearly, 
then,  to  credit  the  proprietor  with  funds  which  can- 
not be  realized  by  the  business  until  a  date  later  than 
the  time  of  credit  is  to  cause  the  business  to  lose  the 
use  of  the  money  and  possibly  even  to  suffer  an  ex- 
pense on  account  of  interest  for  the  time  which  it 
has  to  wait  to  realize  upon  the  investment.  We  shall 
see  in  this  case  that  nine  days  later  the  business  is 
obliged  to  borrow  money  for  operating  uses.  It 
would  not  have  to  do  so  if  the  proprietor  had  turned 
into  it  cash  or  notes  on  which  payment  could  be  im- 
mediately demanded.    Three  of  the  notes  are  payable 


THE  COMMON  LEDGER  ACCOUNTS       67 

only  in  the  future.  The  business,  therefore,  should 
give  the  proprietor  credit  for  his  investment  of  notes 
only  for  theii?  present  worth,  which  is  the  face 
value  less  the  discount.  Let  us  figure  the  dis- 
count on  each  of  these  notes.  It  must  be  observed, 
in  the  first  place,  that  when  a  note  does  not  bear  in- 
terest we  are  concerned,  when  figuring  its  present 
worth,  not  at  all  with  the  length  of  time  which  it 
has  run,  but  only  with  the  length  of  time  which  it 
has  yet  to  run.  For  instance,  if  the  note  is  payable 
two  months  in  the  future,  we  have  to  wait  two  months 
for  collection,  and  neither  the  amount  that  it  will 
call  for  nor  the  time  is  affected  by  the  past  history  of 
that  note, — that  is,  we  do  not  care  whether  it  was 
dated  July  1  to  become  due  March  1,  or  dated  De- 
cember 31  to  become  due  March  1.  Our  period  of 
waiting  is  no  longer  in  one  case  than  in  the  other, 
and  our  discount  is  determined  solely  by  looking  into 
the  future.  We  need  to  know  the  date  of  the  note 
only  in  order  that  we  may  add  its  time  to  that  date 
^nd  determine  its  maturity.  When,  on  the  other 
hand,  a  note  bears  interest,  we  are  concerned  only 
with  its  past  history,  for,  since  it  bears  interest,  the 
future  takes  care  of  itself,  and  we  wish  to  know  only 
how  much/has  accumulated  and  remains  unpaid  of 
the  interest  for  which  it  is  a  good  claim.  In  the  cases 
in  hand,  therefore,  since  the  note  of  George  Eliot  is 
dated  today,  payable  in  two  months,  it  is  worth  less 
than  the  face  value  by  the  amount  of  the  discount 
for  two  months,  or,  at  six  per  cent.,  $10.  Since  the 
note  of  George  Evans  was  dated  December  1,  payable 
in  two  months,  it  will  become  due  February  1,  and 
today  it  is  subject  to  discount  for  one  month,  or,  at 


68  ACCOtJNTIKG  AND  AUDITING 

six  per  cent.,  $10.  Since  the  note  of  George  H.  Lewes 
was  dated  December  16,  payable  in  one  month,  it  will 
become  due  January  16,  and  must  be  discounted  for 
fifteen  days,  or,  at  six  per  cent.,  $1.25.  The  sum  of 
these  discounts  is  $21.25.  This  sum,  if  we  wished  to 
make  a  separate  entry  for  it,  would  be  debited  to  the 
proprietor  and  credited  to  Interest,  for  the  business, 
by  agreeing  to  wait  for  its  money,  will  receive  in  the 
end  more  than  the  sum  credited  to  the  proprietor,  and 
the  difference  will  have  been  earned  by  the  force  of 
interest.  Since  the  note  of  George  Meredith,  dated 
November  1,  bears  interest,  the  interest  accrued  up 
to  January  1  will  be,  at  six  per  cent.,  for  two  months, 
$15;  and  this  $15  the  business  buys  when  it  takes  the 
note.  So  Interest  should  be  debited  as  responsible 
for  this  expenditure  of  money.  We  may  combine 
these  two  entries,  however.  The  $21.25  discount, 
to  be  credited  to  Interest  on  the  first  three  notes,  may 
be  reduced  by  the  $15  to  be  debited  to  Interest,  leav- 
ing a  net  sum,  creditable  to  Interest  and  chargeable 
to  the  proprietor,  of  $6.25;  the  proprietor's  credit, 
therefore,  is  less  than  the  face  of  the  notes  by  this 
amount.  Since  Bills  Receivable  should  include  only 
the  face  values  of  notes,  this  $6.25  does  not  affect 
that  account. 

Although  under  some  refined  systems  of  book- 
keeping the  interest  accrued  on  the  Meredith  note 
would  be  carried  to  an  account  indicating  in  its  title 
exactly  its  purpose,  such,  for  instance,  as  Interest 
Accrued,  in  a  simple  type  of  bookkeeping  we  may 
carry  this  item  directly  to  Interest,  recognizing  that 
here  Interest  represents  an  asset.  This  does  not  in- 
troduce confusion  into  the  books,  however,  for  when 


THE  COMMON  LEDGER  ACCOUNTS       69 

the  interest  is  paid  Interest  will  be  credited,  and  the 
correspondence  of  debit  and  credit  will  wipe  out  the 
item,  showing  that  on  the  purchase  the  business  made 
neither  profit  nor  loss;  and  it  is  true  that  on  this 
item  the  business  has  not  yet  earned  anything  on 
account  of  interest,  for  the  business  has  paid  for  the 
interest  claim  by  crediting  the  proprietor.  When  the 
interest  is  collected,  however,  so  much  of  the  credit 
as  offsets  the  debit  will  apply  to  balance  the  account, 
and  any  excess  will  represent  our  profits  from  hold- 
ing the  note.  We  shall  see  this  worked  out  later. 
So  far  as  the  discounts  are  concernei,  on  the  other 
hand,  the  $21.25  should  properly  be  credited  to  In- 
terest account  because  this  sum  will  be  an  earning 
of  the  business.  That  is  to  say,  we  allow  the  pro- 
prietor credit  for  his  investment,  including  the  face 
of  the  notes  less  the  discount  subtracted,  but  when 
the  notes  are  paid  the  full  face  of  those  notes  will  be 
collected  in  cash,  and  the  difference  between  the 
amount  allowed  the  proprietor,  which  was  the  face 
less  interest,  and  the  amount  actually  collected, 
which  will  be  the  full  face,  is  exactly  what  the  busi- 
ness has  earned  through  the  force  of  interest.  This 
earning  ought  to  be  credited  to  Interest,  and  this 
method  leaves  it  so  credited.  It  is  obviously  unnec- 
essary, though  it  would  be  quite  harmless,  to  credit 
the  proprietor  for  the  interest  accrued  on  the  last 
note — namely,  $15,  debiting  Interest  for  the  same 
amount, — and  then  to  debit  the  proprietor  with  the 
amount  of  discount  on  the  first  three  notes — namely, 
$21.25,  crediting  Interest  for  the  same  amount.  This 
would  represent  the  facts  just  as  they  are,  but 
it  would  involve  two  entries  and  two  postings  both 


70  ACCOUNTING  AND  AUDITING 

to  the  proprietor  and  to  Interest;  whereas  the  desired 
result  is  produced  just  as  well  by  combining  the  two 
into  one  entry  and  subtracting  the  difference  between 
the  discount  and  the  interest  from  the  amount  which 
otherwise  would  be  credited  to  the  proprietor — giving 
$35,000  less  $6.25, — and  crediting  Interest  with  the 
same  difference,  or  $6.25.  The  full  entry  for  the  in- 
vestment would  appear  upon  the  books  in  simple 
journal  form  as  follows : 


Cash 

$15,000 

Eeal  Estate 

15,000 

Bills  Receivable 

5,000 

To  Laurence  Sterne 

$34,993.75 

Interest 

6.25 

Laurence  Sterne  begins  business  this  day. 
He  invests  cash  and  real   estate  as  indicated 
above,  and  notes  as  follows; 
of  George  Eliot,  dated  Jan.  1,  tv^o  months, 

face  1,000,  discount  10.00 

George    Evans,     dated    Dec.     1,    two 

months,  face  2,000,  discount  10.00 

George  H.  Lewes,  dated  Dec.  16,  two 

months,  500,  discount  1.25 


total  discount  21.25 

George  Meredith,  dated  November  1,  on 
demand,  with  int.,  1,500,  interest      15.00 

net  discount  6.25 

Suppose  our  next  transaction  is  the  purchase  of 
office  and  store  f umitiu-e  for  $500  in  cash.  The  entry 
will  have  to  debit  Furniture  and  Fixtures  for  the 
fuU  amount  paid,  because,  if  we  conceive  that  furni- 
ture to  be  on  hand  as  property,  the  department  of  the 
business  which  has  charge  of  it  is  responsible  for  its 
care,  or,  if  we  conceive  that  furniture  to  be  consumed 
in  the  processes  of  the  business,  the  account  must 
indicate  a  responsibility  for  consuming  that  amount 


THE  COMMON  LEDGER  ACCOUNTS  71 

of  value.  For  our  present  purpose,  then,  we  do  not 
need  to  decide  whether  the  account  shall  represent 
]oroperty  supposed  to  remain  on  hand,  or  property 
to  be  consumed  in  the  conduct  of  the  business;  in 
either  case  a  responsibility  is  taken  and  the  account 
should  be  debited.  Cash,  on  the  other  hand,  repre- 
senting the  cash  drawer  or  the  cashier's  department, 
has  yielded  up  a  part  of  its  property  to  enable  us  to 
secure  the  property,  which  is  a  creditable  thing  to  do, 
and,  consequently.  Cash  must  be  credited  to  indicate 
a  surrender  of  property  previously  charged  to  it. 
The  journal  entry  will  be  as  follows: 

1 

Furniture  and  Fixtures  500.00 

To  Cash  500.00 

Bought  office  and  store  furniture 

Next  let  us  pay  $15  for  postage.  It  is  possible  to 
have  one  account,  usually  called  ^* Expense,"  to  in- 
clude a  large  number  of  expense  items  of  various 
sorts,  but  usually  it  is  desirable  to  divide  such  ex- 
pense among  a  number  of  separate  accounts.  One 
of  these,  usually  worth  while  to  maintain  by  itself, 
is  Postage.  In  this  case,  therefore,  we  must  debit 
Postage  to  indicate  that  one  of  the  causes  of  shrink- 
age of  property  is  the  need  of  having  matter  carried 
through  the  mails,  and  to  indicate  for  just  how  much 
of  our  shrinkage  of  assets  this  account  is  responsible. 
We  must  at  the  same  time,  as  in  the  last  case,  credit 
Cash,  for  the  cash  drawer  has  surrendered  a  part  of 
its  property  to  enable  us  to  secure  the  postage  equip- 
ment necessary.  The  entry ,  would  be  made  as 
follows; 


72  ACCOUNTING  AND  AUDITING 


Postage  15.00 

To  Cash  15.00 

Stamps  and  envelopes  bought 

Next  we  may  buy  stationery,  office  books  of  ac- 
count, etc.,  for  cash.  The  account  representing  such 
things  must  be  debited  as  responsible  for  the  outgo, 
and,  as  before.  Cash  must  be  credited.  The  entry  will 
be  as  follows: 


Stationery  125.00 

To  Cash  125.00 

Office  books,  stationery,  ink,  etc.,  bought 

On  the  second  day  of  the  month  we  buy  merchan- 
dise of  Charles  Dickens,  for  which  we  agree  to  make 
payment  in  ten  days,  to  the  amount  of  $4,000,  and  we 
buy  merchandise  from  Charles  Reade  to  the  amount 
of  $3,000,  to  whom  we  pay  cash.  It  would  be  possible 
to  combine  these  two  transactions  into  one  entry,  in 
which  case  Merchandise  would  be  debited  $7,000,  be- 
cause the  merchandise  department  of  the  business  is 
now  responsible  for  this  amount  of  property,  Charles 
Dickens  would  be  credited  $4,000  because  he  has  en- 
trusted the  business  with  this  amount  of  value,  and 
Cash  would  be  credited,  as  previously,  with  $3,000. 
It  might  be  desirable,  however,  to  open  an  account 
with  Charles  Reade  in  the  ledger  in  spite  of  the  fact 
that  immediate  payment  is  made  to  him.  The 
ledger,  it  will  be  remembered,  is  a  book  in  which  all 
items  pertaining  to  the  same  matter  are  classified 
under  one  account.  A  ledger,  of  course,  is  indexed, 
and  it  is  possible  always,  therefore,  to  find  an  item 
in  the  books  by  turning  to  the  corresponding  ledger 


THE  COMMON  LEDGEE  ACCOUNTS  73 

account  as  indicated  by  the  index.  If,  on  the  other 
hand,  the  item  does  not  get  into  the  ledger  at  all, 
there  is  no  convenient  means  of  finding  it,  for  no 
other  book  is  susceptible  of  convenient  indexing.  If 
it  is  probable,  therefore,  that  we  shall  have  other 
transactions  with  Charles  Reade  of  sufficient  impor- 
tance to  make  it  worth  while  to  keep  his  affairs  in- 
dexed, it  is  worth  while  to  open  an  account  with  him 
and  credit  him,  just  as  we  credit  Charles  Dickens, 
for  the  goods  furnished,  and  then  immediately  debit 
him  for  the  cash  payment.  We  will  assume  here, 
however,  that  we  are  not  to  open  an  account  with 
Charles  Reade,  and  that  we  are  to  make  separate 
entries  for  each  purchase.  One  of  these  entries  will 
debit  Merchandise  and  credit  Dickens,  and  the  other 
will  debit  Merchandise  and  credit  Cash.  They  are 
shown  below. 

2 

Merchandise  4000.00 

To  Charles  Dickens  4000.00 

The  following  bill  of  goods  on  10  days'  time, 

purchased    of    him:     [details    should    be 

shown;  or,  if  the  bills  are  numbered  and 

filed,  the  number  only  is  necessary] 

2 
Merchandise  3000.00 

To  Cash 
[Explanation  similar  to  that  for  the  sale  to 
Charles  Dickens] 

On  the  third  of  the  month  we  pay  $65  for  freight. 
It  is  often  worth  while  to  maintain  a  separate  ac- 
count for  freight  in  order  that  we  may  add  the  total 
to  the  sum  of  our  merchandise  cost  at  the  end  of  a 
period  and  yet  in  the  interval  know  what  is  our 
amount  of  expense  in  this  connection.    Our  entry 


U  ACCOUNTIIsrG  AND  AUDITING 

will  be,  of  course,  a  debit  to  Freight  and  a  credit  to 
Cash,  for  Freight  is  responsible  for  the  loss  of  assets. 

3 

Freight  65.00 

To  Cash  65.00 

Freight  paid  on  goods  rec'd  today 

We  next  day  pay  our  telephone  bill  for  three 
months  in  advance.  It  might  be  worth  while  to  open 
a  special  account  for  telegraph,  telephone  and  mes- 
senger service,  but  it  is  assumed  here  that  the  amount 
of  such  expense  is  so  small  that  it  is  not  worth  while 
to  keep  a  separate  account  of  it,  and  its  payment, 
therefore,  is  charged  to  the  miscellaneous  expense 
account  called  by  the  simple  title.  We  debit  Expense 
and  credit  Cash  in  the  form  of  the  entry  shown  below. 

4 

Expense  25.00 

To  Cash  25.00 

Telephone  bill  paid  to  April  1 

On  the  fourth  of  the  month  we  buy  horses  and 
wagon  for  delivery  service,  and  pay  cash,  $500.  This 
is  obviously  of  the  nature  of  an  expense  item.  It  is 
desirable,  however,  to  keep  it  in  an  account  by  itself 
for  the  simple  reason  that  when  we  come  to  make  up 
our  accounts  at  the  end  of  the  year  we  shall,  unless 
we  have  had  bad  luck,  find  that  the  value  is  chiefly 
remaining  and  in  only  small  part  consumed  during 
the  year.  These  items,  then,  though  of  the  nature 
of  expense,  are  chiefly  property  and  are  expense  only 
so  far  as  their  value  is  reduced  by  use  during  the 
year.  It  is  much  simpler  to  debit  this  payment  to 
an  account  by  itself,  and  at  the  end  of  the  year  tp 


THE  COMMON  LEDGER  ACCOUNTS       75 

consider  only  a  part  as  consumed,  than  to  debit  it  to 
Expense  and  at  the  end  of  the  year  make  allowance 
for  most  of  it  remaining  unconsumed.  It  may  be 
well  to  have  an  account  entitled  '^Delivery  Equip- 
ment." To  such  an  account  will  be  carried  charges 
not  only  for  the  horses  and  wagon,  but  also  for  har- 
ness, stable  furnishings,  etc.  The  entry  will  be  as 
below: 

4 

Delivery  Equipment  500.00 

"  To  Cash  500.00 

Horses  and  wagon  bought  for  cash 

We  next  pay  $30  for  advertising.  This  should  be 
debited  to  Expense  and  credited  to  Cash  unless  it  is 
desirable,  because  of  the  amount  of  this  kind  of  ex- 
penditure, to  keep  a  separate  account  for  advertising. 
In  the  entry  as  shown  below  this  has  been  done. 

4 

Advertising  30.00 

To  Cash  30.00 

Paid  for  advertising  in  directory  10.00 

in  Journal     15.00 

in  Bulletin      5.00 

On  January  5  we  seU  goods  to  Anthony  Trollope 
to  the  amount  of  $700,  with  the  understanding  that 
payment  is  to  be  made  in  thirty  days.  Our  books 
must  show  that  we  hold  Anthony  Trollope  re- 
sponsible for  payment,  and  he  must  be  debited;  and 
at  the  same  time  we  must  show  that  the  warehouse 
has  given  up  $700  worth  of  goods,  and,  accordingly, 
is  to  be  credited  for  that  amount.  The  entry  is  shown 
below. 


76  ACCOUNTING  AND  AUDITING 

5 

Anthony  Trollope  '  .  700.00 

To  Cash  •  700.00 

Sold  him,  on  30  days,  as  follows : 
[Details] 

We  on  the  same  day  buy  goods  of  Alexander  Pope 
and  pay  cash.  Let  us  assume  in  this  case  that  we 
wish  to  have  an  account  in  our  ledger  with  Pope 
in  order  that  we  may  have  in  one  place  a  record  of 
all  purchases  made  from  him  and  payments  made  to 
him.  We  must  then  debit  Merchandise  and  credit 
Pope  for  the  full  amount,  $6,000,  and  then  by  another 
entry  debit  Pope  and  credit  Cash  by  the  same 
amount. 

5 
Merchandise  6000.00 

To  Alexander  Pope  6000.00 

Bought  of  him  as  below: 
[Details] 

5 
Alexander  Pope  6000.00 

To  Cash  6000.00 

In  payment  of  merchandise  bought  of  him 
today  X 

On  the  8th  we  pay  wages  of  $25  to  the  bookkeeper, 
$15  each  to  three  clerks,  and  $10  to  the  driver.  This 
transaction  might  be  entered  in  either  of  two  ways. 
If  we  desire  to  keep  on  our  books  a  record  of  all  re- 
lations with  our  employees  in  such  form  that  we 
may  learn  just  when  wages  were  due  each  employee 
and  when  he  was  paid,  we  should  carry  these  items 
through  the  ledger  by  making  an  entry  first  to  credit 
each  with  his  wages,  and  then  another  entry  to  debit 
each  for  the  cash  paid.  In  such  a  case  the  first  entry 
would  be  a  debit  to  Wages,  $80,  and  a  credit  to  the 


THE  COMMOlSr  LEDGER  ACCOUNTS  "S^? 

five  persons  concerned  at  the  amount  belonging  to 
each.  Then,  on  payment,  each  would  be  debited  by 
the  amount  previously  credited,  and  Cash  would  be 
credited  for  the  total.  This  method  shows,  when  all 
wages  have  been  paid,  that  no  sums  are  due  to  any 
of  the  employees,  for  the  debits  and  the  credits  to 
each  cancel;  but  we  have  in  the  end  a  balance  of 
debit  to  Wages  and  of  credit  to  Cash,  and  this  repre- 
sents the  actual  fact, — a  loss  of  cash  because  of  the 
fact,  shown  by  the  debit  to  Wages,  that  men  will 
not  work  for  nothing.  If,  on  the  other  hand,  we  do 
not  care  to  have  a  ledger  account  with  each  clerk, 
because  payments  are  always  made  promptly,  we 
should  omit  both  the  debits  and  the  credits  to  em- 
ployees and  make  the  simple  entry  debiting  Wages 
and  crediting  Cash.  This  is  the  method  in  the  entry 
given  below. 

8 

Wages  80.00 

To  Cash  80.00 

One  week's  wages,  Jan.  1  to  Jan,  6,  as  follows : 
[The  detail  may  give  the  items  or  refer  to  the 
pay  roll] 

On  January  9  we  buy  goods  of  Walter  Scott,  pay- 
ment to  be  made  in  ten  days,  for  $7,000.  This,  as  in 
the  case  of  earlier  purchases,  is  a  debit  to  Mer- 
chandise and  a  credit  to  the  seller,  as  is  shown  below. 


Merchandise  7000.00 

To  Walter  Scott  7000.00 

His  invoice  No.  4 

[This  assumes  that  the  invoice  is  numbered 
and  filed  for  reference] 


78  ACCOUNTIN^G  AND  AUDITING 

On  the  same  day  a  bank  messenger  brings  us  a 
draft  which  Charles  Dickens  has  drawn  on  ns  order- 
ing us  to  pay  to  a  third  party,  three  days  after  we 
see  the  draft,  the  amount  of  our  bill  for  the  purchase 
of  January  2.  We  find  that  since  the  goods  were 
bought  on  an  agreement  to  pay  for  them  in  ten  days, 
payment  ought  to  be  made  on  the  12th,  and  as  this 
draft,  if  accepted  by  us,  will  be  payable  three  days 
from  today,  we  agree  to  make  payment,  and  we  write 
the  word  '^accepted"  across  the  face  of  the  draft, 
with  the  date,  and  our  signature.  As  soon  as  we 
have  done  this  we  no  longer  owe  Charles  Dickens  for 
the  goods.  We  have  made  payment  by  signing  this 
draft  and  promising  to  give  cash  on  the  day  desig- 
nated. If  we  default  in  payment,  he  will  bring  suit 
not  for  payment  on  the  goods,  but  for  payment  of 
the  draft.  Our  books  must  show  this  fact,  and,  there- 
fore, we  must  debit  Charles  Dickens  for  the  payment 
made,  namely,  $4,000,  and  credit  Bills  Payable. 

Novices  at  bookkeeping  more  often  have  trouble 
with  Bills  Payable  than  with  any  other  account.  The 
case  before  us  may  well  illustrate  the  proper  treat- 
ment of  that  account.  It  is  obvious  that  Charles 
Dickens  must  be  debited,  for  we  are  holding  him  re- 
sponsible to  free  us  on  his  books  from  the  debt  due 
on  account  of  the  goods;  he  is  responsible  for  our 
acceptance  of  the  draft.  Something  must  be  credited, 
moreover,  at  the  time  we  debit  Dickens.  This  sug- 
gests that  Bills  Payable  should  receive  the  credit 
because  we  issue  to  him  a  promise  to  pay,  and  Bills 
Payable  is  meant  to  represent  all  promises  for  pay- 
ment in  the  form  of  any  written  document.  It  ought 
to  be  possible,  however,  to  determine  whether  Bills 


THE  COMMON  LEDGEE  ACCOUNTS       79 

Payable  shall  be  debited  or  credited  without  know- 
ing the  other  half  of  the  entry.  In  this  case,  just 
what  has  been  done  for  the  business,  and  by  what! 
Bills  Payable,  as  a  ledger  account,  represents  some- 
thing which  has  stepped  in  and  paid  our  debt,  tem- 
porarily, for  us.  We  ought  to  make  settlement  with 
Dickens  on  the  so-called  book  account — or  sum  due 
for  the  charge  against  us  on  his  books, — ^but  we  are 
released  from  that  responsibility  by  the  fact  that  we 
have  accepted  a  draft.  In  other  words,  something 
has  stepped  in  between  Charles  Dickens  and  us  and 
set  us  free  from  that  responsibility  on  the  book  ac- 
count. Whatever  has  so  set  us  free  is  entitled  to 
credit  for  the  operation  and  is,  of  course,  therefore 
to  be  credited.  So  we  credit  Bills  Payable  just  as 
we  should  credit  any  individual  who  should  come  in 
and  take  this  burden  off  our  hands.  This  is  exactly 
the  sort  of  thing  which  always  leads  to  a  credit  to 
this  account.  It  will  be  found  always  when  a  note  is 
issued  or  a  draft  is  accepted  that  the  paper  signed 
has  relieved  the  business  of  some  responsibility  or 
has  raised  funds  for  it, — as  happens  in  the  next  trans- 
action. We  must,  therefore,  always  credit  the  ac- 
count as  performing  this  service,  just  as  we  should 
credit  an  individual  or  Cash  or  any  other  account 
which  performs  a  service  for  us.  The  entry  f oUows : 

9 

Charles  Dickens  4000.00 

To  Bills  Payable  -  4000.00 

Accepted  his  draft  for  the  amount  of  his 
invoice  credited  January  2 

The  next  day,  finding  need  for  more  money  to 
run  pur  business,  we  make  out  a  note  promising  to 


80  ACCOUNTING  AND  AUDITING 

pay  to  our  bank  $5,000  in  thirty  days.  This  we  take 
to  our  bank  and  get  discounted.  The  bank  will  give 
us,  however,  not  $5,000,  of  course,  because  as  the  note 
does  not  bear  interest  it  demands  the  payment  of 
only  $5,000  at  the  expiration  of  thirty  days;  conse- 
quently, the  bank  will  now  deduct  the  discount,  which 
is  $25  at  six  per  cent.,  and  give  us  $4,975  in  exchange. 
Our  entry  must  indicate  the  fact  that  the  face  of  the 
note  is  $5,000,  and  must  therefore  credit  Bills  Pay- 
able for  that  amount.  Cash,  however,  is  increased 
only  by  the  proceeds  of  the  note,  or  $4,975,  and  there- 
fore must  be  debited  for  only  that  sum.  The  cause  of 
the  discrepancy  between  the  face  of  the  note  and  the 
amount  of  cash  realized  is  the  force  represented  by 
the  account  entitled  Interest,  and  therefore  we  debit 
Interest  for  that  amount.    The  entry  is  shown  below. 

10 

Cash  4975.00 

Interest  25.00 

To  Bills  Payable  5000.00 

Discounted  our  note,  30  days,  at 
National  City  Bank 

On  the  same  day  we  receive  from  George  Mere- 
dith $1,517.25  in  payment  of  his  note  invested  by  the 
proprietor  at  the  opening  of  business.  Since  the  note 
has  run  two  months  and  nine  days,  the  amount  of 
interest  will  be  $17.25.  We  must  debit  Cash  for  the 
total  amount  received,  because  the  cash  drawer  or 
cashier's  department  is  responsible.  "We  must  credit 
Bills  Receivable  by  the  face  of  the  note,  because  the 
department  of  the  business  to  which  notes  were  en- 
trusted (or,  if  one  wishes  so  to  consider  it,  the  drawer 
in  the  safe  in  which  such  notes  are  kept)  has  sur- 


THE  COMMON  LEDGER  ACCOUNTS       ^1 

rendered  that  amount  of  value,  or  has  produced  that 
amount  of  value.  We  credit  Interest  $17.25,  be- 
cause the  force  which  that  account  represents  has 
produced  this  increase  of  property, — a  creditable 
thing  to  do.    The  entry  is  shown  below. 

10 
Cash  1617.25 

To  Bills  Eeceivabl  1500.00 

Interest  17.25 

Eeceived  payment  on  George  Meredith's 
note,  received  Jan.  1,  with  interest 

It  is  interesting  to  note  here  that  when  this  note 
was  received  by  the  business,  on  January  1,  Interest 
was  in  effect  debited  $15.00.  (On  reference  to  the 
entry  it  will  be  seen  that  the  $15.00  was  subtracted 
from  the  $21.25,  which  otherwise  would  have  been 
credited  to  Interest.)  This  $15.00,  we  saw  then,  was 
accrued  interest  purchased  as  an  asset.  Interest  was 
debited  because  Interest  is  responsible, — not  there 
responsible  for  a  loss,  but  responsible  to  collect  the 
money.  Now  we  find  Interest  credited  $17.25.  Ob- 
viously $15.00  of  the  $17.25  is  merely  acquittal  of 
the  responsibility  to  collect,  and  the  rest  is  benefit 
conferred  on  the  business, — clear  gain.  Is  the  $2.25, 
left  as  clear  gain,  correct?  The  business  held  the 
note  nine  days,  and,  at  six  per  cent.,  it  ought  to  earn 
a  sixth  of  a  mill  a  day  for  every  dollar,  or  $2.25  for 
the  nine  days  on  $1,500.  Since  this  is  just  what  our 
books  show,  we  have  proved  the  correctness  of  our 
debits  and  credits  to  Interest  on  this  score. 

On  the  11th  we  buy  goods  of  John  Dryden  and 
pay  cash,  $6,000.  We  do  not  wish  to  open  an  ac- 
count with  John  Drvden  on  the  ledger  because  we  do 

A  &  A-6 


82  ACCOUNTING  AND  AUDITING 

not  expect  to  have  other  transactions  with  him.    Be- 
low is  the  entry. 

11 

Merchandise  6000.00 

To  Cash  6000.00 

Bought  of  John  Dry  den  for  cash,  as  below : 
[Details] 

On  the  12th  we  wish  to  raise  more  money,  and 
consequently  discount  at  our  bank  George  Evans's 
note  invested  by  the  proprietor.  Since  this  note  was 
dated  December  1,  to  run  two  months,  it  will  become 
due  February  1,  and  today  it  is  worth  less  than  its 
face  by  the  discount  for  twenty  days.  The  amount 
of  discount  is  $6.67.  We  get  in  cash,  therefore, 
$1,993.33  and  must  debit  Cash  for  that  amount.  Since 
that  force  in  business  which  we  call  interest  is  re- 
sponsible for  the  deduction  of  $6.67  from  the  face 
of  the  note.  Interest  should  be  debited;  and  Bills  Ee- 
ceivable,  which  has  produced  the  cash,  should  be 
credited  for  the  face,  as  always,  or  $2,000.  The  entry 
is  shown  below. 

12 

Cash  1993.33 

Interest  6.67 

To  Bills  Eeceivahle  2000.00 

Bills  Eeceivahle  No.  2  discounted 

It  will  be  remembered  that  when  we  took  the  note 
Interest  was  credited  for  $10.00  (though  this  amount 
was  combined  with  others  to  make  a  net  credit  for 
four  notes  of  only  $6.25).  The  present  debit  of  $6.67 
leaves  a  net  credit  of  $3.33.  This  is  exactly  correct, 
for  it  shows  that  we  have  earned  $3.33  by  holding 
the  note  a  third  of  a  month.    The  note  was  worth 


THE  commo:n^  ledger  accounts  83 

$1,990  when  we  took  it,  and  is  now  worth  $1,993.33. 
On  the  same  day  we  pay  the  draft  accepted  by  us 
on  the  9th.  Since  this  is  now  a  bill  payable,  we  debit 
Bills  Payable  and  credit  Cash.  The  reason  for  this 
debit  to  Bills  Payable  is  obvious :  we  are  now  obliged 
to  give  up  $4,000  in  cash  because  of  the  claim  out- 
standing against  us  which  originated  in  this  bill 
payable.  We  credited  Bills  Payable  for  stepping  in 
between  us  and  our  debt  at  the  time  we  accepted 
the  draft,  and  now  that  the  bill  payable  must  be  met 
we  debit  it  for  causing  the  outgo.  The  two  items 
on  that  account  balance  each  other.  Always  when 
a  bill  payable  is  met  the  account  is,  of  course,  debited 
as  responsible  for  the  loss  of  property.  The  entry 
will  appear  as  shown  below. 

Bills  Payable  4000.00 

To  Cash  4000.00 

Paid  our  acceptance  of  Jan.  9 

On  the  13th  we  sell  goods  to  Jonathan  Swift, 
payable  in  ten  days,  for  $575.  The  entry  is  as  fol- 
lows : 

13 

Jonathan  Swift  575.00 

To  Merchandise  575.00 

Sold  him  goods  as  follows,  on  10  days 
[Details] 

On  the  15th  we  sell  goods  to  Richard  Steele,  to  be 
paid  for  in  ten  days,  for  $200.    The  entry  is  as  below. 

15 

Eichard  Steele  200.00 

To  Merchandise  000.00 

[Details] 


M  ACCOUNTING  AND  AtlDITINO 

On  the  16th  the  note  of  G.  H.  Lewes,  invested  in 
the  business  by  the  proprietor  on  January  1,  is  paid. 
Since  cash  comes  in,  cash  account  is  debited;  and 
since  the  origin  of  this  receipt  lies  in  property  sur- 
rendered by  the  bills  receivable  drawer  in  the  safe, 
Bills  Receivable  is  credited,  as  shown  below.  The 
business  has  made  a  profit  by  holding  the  note,  for 
it  allowed  the  proprietor  only  $498.75  on  Jan.  1;  the 
discount  was  then  credited,  however,  and  so  only  the 
face  needs  now  to  be  entered. 

16 

Cash  500.00 

To  Bills  Receivable  500.00 

Note  of  G.  H.  Lewes,  dated  Dec.  16,  paid 

On  the  same  day  we  sell  to  Joseph  Addison  in  ex- 
change for  his  note,  payable  in  thirty  days,  $600 
worth  of  goods.  If  for  any  reason  we  wish  Addison's 
account  to  appear  on  the  ledger,  we  should  debit  him 
and  credit  Merchandise,  and  then  by  a  second  en- 
try we  should  debit  Bills  Receivable  and  credit  him. 
We  will  assume  in  this  case,  however,  that  we  have 
no  use  for  Addison's  account  in  the  ledger,  and  there- 
fore merely  debit  Bills  Receivable  because  the  safe 
is  responsible  for  that  amount  of  property,  and  credit 
Merchandise  for  surrendering  that  amount  of  value. 
If  the  goods  are  to  be  paid  for  under  ordinary  cir- 
cumstances in  thirty  days,  and  his  note  reads  as  pay- 
able in  thirty  days,  no  discount  is  to  be  considered. 
If,  however,  the  goods  ought  to  be  paid  for  in  ten 
days,  and  the  note  reads  as  payable  in  thirty  days,  he 
should  pay  the  difference  of  discount  in  cash.    We 


THE  COMMON  LEDGEE  ACCOUNTS       85 

will  assume  in  this  case  that  thirty  days  is  a  normal 
time  for  payment  of  the  goods  and  that,  therefor,e, 
the  note  is  an  exact  equivalent.  The  entry  is  shown 
below. 

16 

Bills  Eeceivable  600.00 

To  Merchandise  600.00 

Sold  goods  to  Jos.  Addison,  for  his  note, 
30  days 
[Details] 

On  January  17  we  sell  goods  to  George  Berkeley 
for  cash,  $300,  as  indicated  below: 

17 

Cash  300.00 

To  Merchandise  300.00 

Sold  goods  to  George  Berkeley,  for  cash 
[Details] 

On  the  next  day  we  issue  our  own  note  for  thirty 
days,  bearing  interest,  and  borrow  its  face  value  at 
a  banli  for  $4,000.  It  will  be  seen  that  here,  since  the 
note  itself  bears  interest,  there  is  no  discount  to  be 
subtracted,  for  at  payment  a  larger  sum  than  $4,000 
must  be  paid  exactly  equivalent  to  the  interest 
charge  for  the  lapse  of  time.  We  have,  therefore, 
merely  to  debit  Cash  and  credit  Bills  Payable,  for 
Bills  Payable  has  rendered  the  business  the  service 
of  raising  for  it  this  amount  of  cash.  On  payment, 
however,  since  we  must  pay  more  than  $4,000,  we  will 
debit  Interest  and  Bills  Payable  and  credit  Cash. 
The  entry  for  the  issue  of  the  note  is  shown  below. 


86  ACCOUNTING  AND  AUDITING 

18 

CaBh  4000.00 

To  Bills  Payable  4000.00 

Issued  our  note  for  $4000,  with  interest, 
and  borrowed  on  it  at  the  National  City 
Bank,  30  days  i 

On  the  19th  we  pay  Walter  Scott  in  full,  as  is 
shown  by  the  following  entry: 


Walter  Scott  7000.00 

To  Cash  7000.00 

Paid  him  his  bill  of  Jan.  9 

On  the  same  day  we  pay  insurance  to  the  amount 
of  $100.  This  might  be  debited  to  Expense,  except 
as  it  is  desirable  to  keep  all  insurance  costs  by  them- 
selves imtil  the  end  of  the  year.  The  latter  is  what 
is  done  in  the  entry  below. 

19 

Insurance  100.00 

To  Cash  100.00 

Policy  No.  64,510,  3  yrs.,  on  stock  of  goods 

On  the  2^d  we  pay  $300  for  remodeling  our  ofi&ces. 
If  it  is  supposed  that  this  remodeling  constitutes 
permanent  improvement,  it  will  be  charged  to  Real 
Estate.  If,  on  the  other  hand,  it  is  supposed  to  be 
merely  temporary,  as  a  part  of  the  expense  of  con- 
ducting the  business,  it  must  be  charged  to  Expense 
or  to  some  subdivision  of  that  account.  We  here 
suppose  it  to  be  a  permanent  improvement,  and 
therefore  enter  it  as  shown  below: 


THE  COMMON  LEDGER  ACCOUNTS  87 

_     22 

Eeal  Estate  300.00 

To  Cash  300.00 

Bill  of  Star  Building  Co.  for  remodeling 
offices 

On  the  same  day  we  let  to  a  tenant  one  of  our  re- 
modeled offices,  and  he  pays  three  months'  rent  in 
advance,  to  the  amount  of  $100.  It  is  obvious  that 
Cash  must  be  debited  as  responsible  for  the  money, 
and  some  accoimt  representing  earnings,  of  a  differ- 
ent sort  from  those  ordinarily  made  in  the  common 
conduct  of  the  business,  must  be  credited.  That  is 
to  say,  it  is  worth  while  to  distinguish  between  the 
profits  made  on  merchandise  sold,  and  the  profits 
arising  from  such  things  as  interest,  commission,  and 
rents.  It  would  ordinarily  be  desirable  to  credit  this 
item  to  Rent,  as  shown  below: 

22 
Cash  100.00 

To  Eent  100.00 

Three  months^  rent  paid  in  advance 
for  office,  by  Edmund  Burke 

On  January  23  Jonathan  Swift's  bill  is  paid,  as 
shown  below: 

23 
Cash  576.00 

To  J.  Swift 
In  payment  of  his  bill  of  Jan.  13 

On  the  same  day  we  pay  for  coal,  $100.  Though 
this  might  be  carried  to  Expense,  if  the  coal  con- 
sumption is  large  it  will  be  desirable  to  compare  the 
cost  this  year  with  subsequent  years  and,  therefore, 
to  charge  this  to  an  account  by  itself,  as  is  shown 
below: 


88  ACCOUNTING  AND  AUDITING 

23 
Fuel  100.00 

To  Cash  100.00 

[Explanation  should  specify  dealer,  kind, 
and  amount,  or  the  bill  as  filed] 

On  the  24th  we  subscribe  and  pay  $100  for  the 
benefit  of  sufferers  by  a  flood  in  a  distant  part  of 
the  country.  This  is  no  part  of  expense  in  the  or- 
dinary sense,  and  may  be  charged  either  to  the  pro- 
prietor, if  he  is  supposed  to  make  the  subscription 
on  his  own  behalf,  or  to  Profit  and  Loss,  if  the  sub- 
scription is  made  by  the  business.  In  the  latter  case, 
as  is  assumed  below,  we  simply  hold  responsible  for 
a  loss  of  assets  the  general  balance  of  income  for  the 
year.  This,  if  profit  is  made,  is  reduced  by  this 
amount,  or,  if  a  loss  is  suffered,  is  increased  to  the 
same  extent.    The  entry  is  as  follows: 

24 

Profit  &  Loss  100.00 

To  Cash  *  100.00 

Subscription  to  flood  sufferers  * 

We  sell  goods  for  cash,  as  show^n  below: 

24 
Cash  -  1200.00 

To  Merchandise  1200.00 

[The  detail  should  indicate  the  name  of  the 
purchaser  for  any  large  item,  as  well  as  the 
goods  sold.] 

On  the  next  day  we  draw  a  draft  on  Anthony 
Trollope,  payable  in  ten  days,  to  our  ,own  order,  for 
the  amount  of  his  bill  due  February  4.  If  this  draft 
is  not  accepted  by  Trollope  it  is  nothing  but  a  piece 
of  valueless  paper,  and,  therefore,  we  cannot  make 
any  debit  or  credit  until  we  know  its  fate.   We  make 


THE  COMMO]^  LEDGER  ACCOUNTS  89 

a  memorandum  of  its  drawing  but  can  at  the  present 
time  do  nothing  else. 

On  the  same  day  a  bill  for  dry  goods  purchased 
by  the  proprietor's  wife  is  paid  out  of  the  cash 
drawer.  This  is  chargeable,  of  course,  to  his  account, 
as  shown  below: 

25 
Laurence  Sterne  ,  75.00 

To  Cash  75.00 

Dry  goods  bill  paid  for  Mrs.  Sterne 

Richard  Steele's  bill  is  paid  in  cash,  as  indicated 
below: 

25 

Cash  200.00 

To  Richard  Steele  200.00 

Bill  of  Jan.  15  paid 

On  December  26  we  receive  notice  that  the  draft 
drawn  on  TroUope  has  been  accepted.  This  is  now 
Troll  ope 's  promise  to  pay  and  is,  therefore,  for  us 
a  bill  receivable,  and  TroUope  has  met  his  obligation 
to  pay  for  the  goods  sold  him  on  January,  5.  We  ac- 
cordingly debit  Bills  Receivable,  for  the  bills  receiv- 
able drawer  or  file  is  responsible  for  the  property, 
and  credit  TroUope  for  giving  this  property  to  the 
business,  as  shown  below: 

Bills  Receivable  700.00 

To  A.  TroUope  700.00 

Our  draft  on  him,  for  his  bill  of  Jan.  5, 
accepted  by  him 

On  the  27th  we  discount  at  our  bank  the  draft 
which  we  received  the  preceding  day  accepted  by 
Anthony  TroUope.    Since  this  is  his  promise  to  pay. 


90  ACCOUNTING  AND  AUDITING 

and  we  guarantee  its  payment  on  discounting  it  at 
the  bank — ^just  as  we  do  any  promissory  note, — the 
bank,  if  our  credit  is  good,  will  lend  us  money  upon 
it.  We  receive  cash  for  the  face  value  less  the  dis- 
count for  the  time  remaining  before  maturity.  Since 
this  loss  of  discount  is  due  to  that  force  in  business 
which  is  represented  by  Interest,  that  account  is 
debited  for  93  cents.  Cash  is  debited  for  the  net  pro- 
ceeds, and  Bills  Receivable,  which  has  now  surren- 
dered this  amount  of  value,  is  credited  for  the  full 
face.  It  is  obvious  that  TroUope's  name  does  not 
need  to  appear  here  as  either  debited  or  credited,  for 
he  was  properly  credited  when  he  accepted  the  draft. 
The  entry  for  this  transaction  follows. 


700.00 


On  January  29  the  proprietor  draws  for  his  own 
use  $150  in  cash.  This  cash  withdrawal  should  be 
debited  to  the  proprietor  exactly  as  any  other  pay- 
ment of  cash  to  an  individual  should  be  debited  to 
that  individual's  account.  It  must  be  clearly  under- 
stood that  the  books  are  kept  for  the  business  as 
an  entity  independent  of  the  proprietor.  The  pro- 
prietor is  liable  for  any  debts  of  the  business  and  he 
will  take  any  profits  accruing  to  it;  but  so  long  as 
we  are  keeping  books  for  the  business  we  must  not 
confuse  its  affairs  with  the  proprietor's  personal  af- 
fairs. The  balance  of  the  proprietor's  account  should 
at  all  times  show  how  much  he  now  has  invested  in 


27 

Cash 
Interest 

To  Bills  Receivable 
Discounted   TroUope's  acceptance  received 
yesterday 

699.07 
.93 

THE  C0MM0:N'  LEDGEE  ACCOTJNTS  91 

the  business.  It  may  be  desirable  to  keep  two  ac- 
counts for  the  proprietor,  one  of  which  shall  con- 
tain his  capital  investment  and  the  other  a  record  of 
his  personal  drawings  out  of  the  probable  profits. 
Ordinarily,  unless  there  are  complications  due  to 
partnership,  it  makes  absolutely  no  difference 
whether  the  capital  and  withdrawal  accounts  are 
combined  or  not,  for  the  combined  balance  of  the 
two  accounts  is  the  net  investment;  but  when  a 
partnership  agreement  provides  for  interest  on  capi- 
tal and  on  imdrawn  salaries,  it  may  be  essential  to 
know  what  portion  of  a  partner's  total  credit  is  upon 
investment  and  what  portion  is  upon  salary.  We 
here,  having  only  a  single  proprietorship,  charge  this 
withdrawal  to  the  proprietor's  capital  account. 

29 

Laurence  Sterne  150.00 

To  Cash  150.00 

Cash  drawn  for  personal  use 

On  the  30th  we  buy  goods  of  Dickens,  and  sell 
goods  to  Swift  and  Steele.  Combining  the  sales,  we 
get  the  following  entries: 

30 

Merchandise  1000.00 

To  Charles  Dickens  '    .  1000.00 

[Details] 

30 

Jonathan  Swift  500.00 

Eichard   Steele  500.00 

To  Merchandise  1000.00 

[Details] 

We  are  now  in  a  position  to  study  a  little  more 
deeply  the  significance  of  some  of  these  accounts, 


92  ACCOUNTING  AND  AUDITING 

and  to  note  a  few  accounts  that  are  new  to  us.    Let 
us  review  summarily  the  old  ones  as  we  go  on. 

Cash,  as  we  have  seen,  represents  money,  checks, 
and  money  orders,  but  does  not  represent  notes  and 
drafts.  Since  Cash  is  debited  for  all  such  items  re- 
ceived, and  is  credited  for  all  such  items  paid,  and 
since  no  more  can  have  been  paid  out  than  has  been 
received.  Cash  must  always  have  the  balance  on  the 
debit  side  if  it  has  any  balance  at  all.  An  apparent 
exception  to  this,  in  books  which  treat  bank  balances 
as*  if  they  were  cash,  is  when  a  bank  account  has  been 
overdrawn.  In  such  a  case  the  payments  appear  to 
be  in  excess  of  the  receipts.  Theoretically,  this  is 
true;  but  its  occurrence  is  bad  bookkeeping,  for  the 
moment  a  bank  account  has  been  overdrawn,  whether 
with  the  consent  of  the  bank  officials  or  not,  an  entry 
should  be  made  on  the  receipts  side  of  the  cash  book, 
crediting  the  bank  and  debiting  Cash  for  the  amount 
of  the  overdraft.  Such  an  overdraft  is  distinctly  a 
loan  from  the  bank  and  should  be  entered  as  such. 
The  business  is  liable  for  its  repayment  just  as  much 
as  it  is  liable  for  any  other  debt,  and  such  a  debt 
should  appear  upon  the  books. 

Similarly,  Bills  Receivable,  which  represents 
notes  and  drafts  collectible,  can  have  a  balance  on 
the  debit  side  only.  Bills  Eeceivable  is  debited  for 
all  notes  and  drafts  received,  and  is  credited  for  all 
notes  and  drafts  surrendered  or  collected,  and  since 
no  more  can  have  been  surrendered  or  collected  in 
cash  or  other  property  than  the  debits  called  for, 
it  is  impossible  that  the  credits  to  Bills  Receivable 
should  ever  exceed  the  debits,  and  the  amount  of 
debit  balance  must  always  equal  the  face  value  of 


THE  COMMON  LEDGER  ACCOUNTS       93 

the  notes  on  hand.  An  apparent  exception  to  this  is 
in  connection  with  notes  bearing  interest,  for  then 
we  collect  a  sum  which,  by  the  amount  of  the  interest, 
is  larger  than  the  face.  It  is  to  be  noted,  however, 
that  this  excess  payment  is  no  part  of  the  Bills  Re- 
ceivable proper,  but  is  simply  a  payment  for  interest, 
and  should  be  credited  to  Interest.  So  it  remains 
true  that  Bills  Receivable  account  cannot  have  been 
credited  for  more  than  its  debits,  and  its  balance  will 
be  the  face  value  of  notes  on  hand. 

Bills  Payable  account,  representing  the  promises 
of  the  business  to  pay  either  on  promissory  notes  or 
on  drafts,  will  be  credited  for  all  notes  issued  and 
debited  for  all  notes  paid;  and  since  not  more  can 
have  been  paid  upon  Bills  Payable  than  the  face  of 
the  notes  themselves  calls  for,  the  balance  will  al- 
ways be  on  the  credit  side,  and  the  amount  of  the 
balance  will  always  be  the  face  of  all  notes  still  out- 
standing. It  is  true,  of  course,  that  sometimes  a  note 
calls  for  the  payment  of  a  larger  sum  than  that  in- 
dicated on  its  face,  for  interest  may  be  included;  in 
such  case,  however,  it  must  be  recognized  that  the 
excess  payment  is  interest  pure  and  simple,  and  must 
be  debited  to  Interest;  so  it  still  remains  true  that 
not  more  can  have  been  paid  on  Bills  Payable  proper 
than  the  total  of  the  Bills  Payable  credits,  and  the 
balance  is  the  amount  outstanding. 

All  pure  property  accounts  must  have  the  balance 
on  the  debit  side,  if  any  balance  at  all  remains;  for 
since  each  such  account  is  debited  originally  for  the 
value  of  the  property  belonging  to  the  department 
of  the  business  represented  by  the  account,  and  since 
each  is  credited  for  what  is  surrendered  by  that  de- 


94  ACCOUNTING  AND  AUDITING 

partment,  any  balance  must  represent  the  amount 
of  property  on  hand.  If  any  elements  of  profit  are 
connected  with  property  accounts — such  as  we  have 
seen  in  the  case  of  Merchandise, — the  profit  makes 
the  account  to  a  certain  extent  nominal,  and  its  treat- 
ment at  the  end  of  the  year  must  be  in  part  that 
accorded  to  nominal  accounts.  Normally,  however, 
property  accounts  are  not  supposed  to  have  profit 
connected  with  them,  though  most  of  them  need,  an- 
nually or  oftener,  to  be  credited  for  depreciation  in 
case  repairs  have  not  kept  the  property  up  to  its 
original  value.  This  credit  subtracted  from  the  debit 
standing  originally  on  the  books  should  show  the  net 
value  of  the  property  on  hand,  which  is  the  debit 
balance  remaining. 

Of  property  accounts  having  some  admixture  of 
profits.  Merchandise  is  the  most  common  and  there- 
fore best  worth  detailed  study.  We  saw  that  it  is 
partly  a  real  account,  representing  property,  and 
partly  a  nominal  account,  representing  profit  or  loss. 
This  introduces  some  complication  and  awkwardness 
of  interpretation.  Let  us  examine  it  further.  Mer- 
chandise may  have  a  balance  on  either  side  because 
it  is  commonly  debited  for  merchandise  bought  at 
the  cost  price,  and  is  commonly  credited  for  mer- 
chandise sold  at  the  selliug  price.  The  difference 
between  the  tw^o  prices  may  be  so  great  as  to  throw 
the  balance  on  the  credit  side  even  though  a  con- 
siderable amount  of  merchandise  is  still  on  hand. 
Before  we  can  know  whether  this  account  properly 
represents  an  earning  or  a  loss,  then,  we  must  take 
into  account  the  amount  of  merchandise  on  hand. 
Let  us  try  out  a  number  of  cases  of  this  sort. 


THE  COMMON  LEDGER  ACCOUNTS       95 

Suppose  the  amount  of  merchandise  on  hand  at 
the  beginning  of  the  year  cost  $15,000,  and  that  $40,- 
000  worth  was  bought  during  the  year.  This  gives 
a  total  debit  of  $55,000.  Suppose  next  that  the  mer- 
chandise sold  and  credited  amounts  to  $50,000.  Ap- 
parently we  have  a  debit  balance  of  $5,000  which,  if 
we  were  to  treat  Merchandise  as  we  ordinarily  treat 
property  accounts,  would  indicate  $5,000  worth  of 
merchandise  on  hand.  If,  however,  our  selling  price 
has  been  much  higher  than  the  buying  price,  it  is 
obvious  that  the  $50,000  worth  sold  cost  us  a  good 
deal  less  than  $50,000, — how  much  less  we  cannot  tell 
by  any  figures  before  us.  If,  now,  we  learn  that  we 
have  $20,000  worth  of  goods,  figured  at  cost  price, 
still  remaining,  the  goods  sold  cost  us  $35,000;  and 
we  know  this  because  we  know  that  of  the  $55,000 
debited  to  Merchandise  ($15,000  worth  on  hand  at 
the  beginning  of  the  year  and  $40,000  worth  pur- 
chased later),  we  have  $20,000  still  remaining,  so  that 
$35,000  worth  must  have  been  sold.  If  the  $35,000 
worth  sold  brought  us  $50,000,  as  the  credits  to  Mer- 
chandise indicate,  the  gain  is  $15,000. 

Now  let  us  change  our  supposition.  Suppose, 
though  we  are  beginning  the  year  as  before,  with 
$15,000,  and  purchased  during  the  year  as  before 
$40,000,  and  sold  during  the  year  as  before  $50,000, 
the  amount  now  on  hand  is  $5,000.  It  is  obvious 
that  we  have  made  no  profit;  this  is  shown  by  sub- 
tracting the  $5,000  now  on  hand  from  the  $55,000 
total  debits,  leaving  $50,000  as  the  cost  of  the  goods 
sold.  This  compared  with  the  credits  indicates  that 
we  really  got  only  cost  price  for  sales. 

Let  us  try  another  case.    Suppose  the  debits  to 


96  ACCOUNTING  AND  AUDITING 

be  $55,000  ^s  before,  the  credits  to  be  now  but  $20,- 
000,  and  the  inventory  to  be  $40,000.  It  is  obvious 
in  this  ease  that  the  profits  are  $5,000;  for  the  amount 
on  hand,  $40,000,  subtracted  from  the  total  debits, 
$55,000,  leaves  $15,000,  at  cost  price,  for  the  goods 
sold;  and  since  the  sales  amounted  to  $20,000  and 
the  cost  of  the  sales  to  $15,000,  the  balance  is  $5,000 
profit. 

The  same  result  would  have  been  attained  each 
time  if,  instead  of  subtracting  the  inventory  from  the 
debits,  we  had  added  it  to  the  credits;  for  the  credits 
then  would  have  represented  what  we  have  received 
for  our  sales  plus  what  we  have  yet  on  hand,  which 
ultimately  is  to  be  credited.  The  difference  between 
what  it  cost  us  to  secure  the  merchandise  and  what 
the  merchandise  is  worth,  both  sold  and  in  stock,  is 
the  profit. 

Let  us  take  one  case  more,  and  use  the  second 
method.  Supposing  the  debits  to  be  as  before,  $55,- 
000,  let  us  assume  the  sales  to  be  $60,000  and  the 
goods  remaining  on  hand  to  be  $15,000.  Here  the 
profit  will  be  $20,000,  because  our  sales  have  already 
realized  $5,000  more  than  the  total  cost  of  all  mer- 
chandise, and  we  have  $15,000  yet  on  hand;  the  two 
added  give  us  $20,000  profit.  Eeverting  to  our  for- 
mer method  for  this  case,  we  get  figures  as  follows : 
our  present  stock  of  $15,000,  subtracted  from  our 
debits,  $55,000,  leaves  us  $40,000  for  the  cost  of  the 
goods  sold;  as  they  brought  $60,000,  our  profit  is 
$20,000.  Neither  method,  it  is  to  be  noted,  counts 
profit  on  future  sales,  for  we  are  figuring  the  in- 
ventory only  at  cost  price,  and  we  are  doing  this 
only  because  we  must  figure  it  on  some  basis  in  order 


THE  COMMON  LEDGER  ACCOUNTS       97 

to  determine  what  has  been  the  profit  on  the  goods 
sold.  If  the  inventory  of  $15,000  should  prove  next 
year  to  bring  in  nothing,  it  would  still  be  true  that 
our  profits  this  year  have  been  $20,000.  This  year's 
profits  are  entirely  independent  of  the  inventory  of 
$15,000  put  upon  the  goods  now  on  hand.  The  $15,- 
000  is  used  only  in  order  that  we  may  determine  how 
many  of  the  total  goods  debited  to  Merchandise  have 
been  utilized  in  getting  the  $60,000  worth  of  sales, 
and  the  profit  of  $20,000  really  comes  from  compar- 
ing the  $40,000  of  cost  of  sales  with  the  $60,000  of 
results  from  sales. 

Another  method  of  treating  Merchandise,  which 
proves  well  worth  while  in  large  businesses,  may  be 
noted  here.  It  does  not  get  rid  of  the  requirement 
of  an  inventory;  no  method  can  do  that  unless  cost 
can  be  figured  exactly  on  all  articles  sold,  for  only 
when  we  have  either  the  cost  of  goods  sold  or  the 
cost  of  the  goods  remaining  on  hand  can  we  learn 
our  profit  from  sales.  By  this  method,  separate  ac- 
counts are  kept  f Qr  each  of  the  three  relations  which 
Merchandise  has  with  the  business  as  a  whole.  One 
account.  Inventory,  represents  the  inventory,  or  re- 
sult of  taking  account  of  stock,  at  the  beginning  of 
the  year;  this  is  kept  constant  through  the  year 
because  no  other  debits  and  no  credits  are  made  to 
it.  Another  account.  Purchases,  shows  purchases; 
and  to  this  account  are  debited  at  the  purchase  or 
cost  price  all  purchases  made  during  the  year.  This 
would  be  a  property  account  if  it  were  credited  for 
all  sales  of  goods  at  the  purchase  price,  for  then  the 
difference  between  the  debits  and  the  credits  to  this 
account  would  show  what  value  in  goods  bought  since 

A  &  A-7 


98  ACCOUNTING  AND  AUDITING 

the  beginning  of  the  year  is  still  on  hand.  A  diffi- 
culty is  that  it  is  usually  impossible,  at  least  in  any 
businesses  but  those  of  few  sales,  to  figure  on  all 
items  of  sales  the  actual  cost.  Consequently  it  is 
usual  under  this  plan  to  make  no  credits  to  the  pur- 
chases account  except  when  goods  purchased  are  re- 
turned. Sales  are  credited  to  a  separate  account 
bearing  that  name,  and  are  always  entered  at  the  sell- 
ing price.  Under  this  plan,  then,  profit  is  learned  by 
adding  the  inventory  at  the  end  of  the  year  to  the 
sales,  and  from  this  sum  subtracting  the  sum  of  the 
inventory  at  the  beginning  of  the  year  and  the  pur- 
chases. We  are  not  then  much  better  off  as  regards 
the  profit  on  merchandise  than  under  the  plan  of  a 
single  account  for  merchandise,  discussed  in  the  pre- 
ceding paragraph.  The  real  value  of  this  three-account 
treatment  of  merchandise  is  that  with  it  we  know 
the  magnitude  of  our  business  as  indicated  by  the 
total  amount  of  purchases  and  the  total  amount  of 
sales.  Under  the  single  account  for  merchandise,  if 
we  debit  Merchandise  when  goods  are  bought  and 
then  return  some  of  these  goods,  we  must  credit 
Merchandise  for  the  return  at  the  cost  price;  but  we 
commonly  also  must  credit  merchandise  sales  to  the 
single  merchandise  account  at  selling  price.  Our 
credits  to  Merchandise,  then,  comprise  two  sets  of 
items :  one  is  returned  purchases  at  cost,  the  other  is 
sales  at  selling  price.  This  total  credit  does  not 
properly  indicate  the  magnitude  of  our  sales,  and, 
consequently,  our  merchandise  account  is  not  a 
proper  index  of  the  magnitude  of  our  business.  Simi- 
larly, we  debit  Merchandise  not  only  for  goods  pur- 
chased at  cost  price,  but  for  sales  returned  at  selling 


THE  COMMOI^  LEDGER  ACCOUNTS  99 

price,  and  hence  the  debit  to  Merchandise  does  not 
indicate  the  volume  of  our  purchases.  Only  so  far 
as  the  three  separate  accounts  for  Merchandise  avoid 
this  difficulty  is  the  three-account  system  for  mer- 
chandise better  than  the  old-fashioned  method  of  a 
single  account. 

We  have  to  conclude,  therefore,  that  in  any  case 
our  Merchandise  account  is  not  quite  one  thing  or  an- 
other. It  is  not  quite  a  real  account  and  not  quite  a 
nominal  account,  but  it  may  be  made  either  of  these. 
Whenever  we  take  account  of  stock,  we  can  remove 
from  Merchandise  the  profit  made  on  sales  and  trans- 
fer it  to  another  account;  the  balance  is  then  the  cor- 
rect property  valuation.  This  awkwardness  in  Mer- 
chandise seems  unfortunate,  but  it  chances  that  it  is 
due  not  at  all  to  bookkeeping  defects,  but  to  a  mere 
defect  of  fact.  If  the  managers  of  the  business  can- 
not learn  what  has  been  the  actual  cost  of  sales,  be- 
cause of  the  expense  of  keeping  and  classifying  the 
records,  it  is  not  to  be  expected  that  accounting 
can  show  in  Merchandise,  or  any  accounts  represent- 
ing merchandise,  just  what  is  the  stock  of  goods  on 
hand.  It  is  only  where  it  is  possible  to  keep  record  of 
sales,  and  look  up  the  cost  price  of  all  such  sales,  that 
merchandise  account  can  be  made  exactly  either  a 
property  account  or  a  profit  account.  If  such  a  record 
of  the  cost  of  sales  were  made,  the  books  could  al- 
ways be  kept  in  accordance  with  the  facts.  If  Pur- 
chases was  then  credited  every  day  with  the  total 
cost  of  goods  sold,  the  debit  balance  of  Purchases 
would  always  be  the  purchases  added  since  the  be- 
ginning of  the  year  and  now  on  hand ;  and  this  sum, 
added  to  the  inventory  at  the  beginning  of  the  year, 


100  ACCOUNTING  AND  AUDITING 

would  be  the  total  stock  of  goods  on  hand;  or,  if 
more  had  been  sold  than  was  purchased  after  the  be- 
ginning of  the  year,  the  credit  excess  when  carried 
to  Inventory  (as  at  the  beginning  of  the  year)  would 
leave  as  a  balance  a  sum  equal  to  the  stock  of  goods 
on  hand.  The  sales  account,  similarly,  would  be  deb- 
ited for  all  sales  at  cost — because,  of  course,  the  sales 
would  be  responsible  at  cost  for  the  goods  disposed 
of, — and  would  show  as  a  balance,  since  it  is  credited 
with  all  sales  at  selling  price,  the  gross  profit  on  sales. 

It  is  obvious  that  Wages,  Printing,  Postage,  In- 
surance, Taxes,  etc.,  all  of  which  represent  varieties 
of  expense,  will  have  a  balance  on  the  debit  side, 
for  they  are  responsible  for  outgoes.  If,  on  the  other 
hand,  we  find  that  one  of  our  workmen  has  been  en- 
gaged in  something  for  his  employer's  personal  use, 
though  his  name  appears  on  the  pay-roll  as  if  he  were 
engaged  in  the  regular  work  of  the  business,  we  cor- 
rect the  error  by  debiting  the  proprietor  and  credit- 
ing Wages.  If  some  of  our  stationery  originally 
charged  to  Stationery  is  sold,  Stationery  will,  of 
course,  be  credited  for  the  amount.  Eepayment  of 
insurance  premium  on  the  cancellation  of  a  policy 
will  be  credited  to  Insurance.  Credits  to  these  ac- 
counts are  rare,  however. 

Commission,  representing  both  commissions  al- 
lowed and  commissions  earned,  may  have  a  balance 
on  either  side,  for  the  amounts  earned  may  exceed 
or  fall  below  those  allowed.  If  Commission  shows 
a  credit  balance,  it  is  obvious  that  since  it  is  credited 
for  earnings — because  to  earn  commissions  is  a 
creditable  thing, — and  is  debited  for  commissions  in- 
curred— since  Commission  is  responsible  for  the  out- 


THE  COMMON  LEDGER  ACCOUNTS  101 

go, — a  credit  balance  shows  a  net  profit  on  that  score; 
and  a  debit  balance  shows  a  net  loss  on  that  score. 

Interest,  similarly,  may  have  a  balance  on  either 
side.  A  credit  balance  represents  net  earnings  of  in- 
terest over  interest  charges  incurred,  and  a  debit  bal- 
ance represents  excess  of  interest  allowed  to  others 
over  interest  earned. 

The  three  general  types  of  accounts  have  been 
illustrated  in  the  particular  accoimts  just  described; 
but  if  it  were  not  possible  to  bring  together  the  vari- 
ous elements  of  a  business  and  make  a  summary  of 
all  operations  and  relations,  it  would  be  difficult  at 
the  end  of  the  year  to  record  on  the  books  any  very 
clear  statement  of  the  results  as  a  whole.  As  a 
means  of  bringing  together  the  various  nominal  ac- 
counts, a  profit  and  loss  account  is  always  kept.  To 
this,  ultimately,  the  balances,  of  the  other  nominal 
accounts  are  carried.  Indeed,  Profit  and  Loss  may 
serve  another  purpose  than  merely  to  summarize  the 
transactions  of  an  earning  period.  Throughout  the 
com-se  of  any  year  there  are  likely  to  be  some  losses 
and  gains  of  an  unusual  and  rather  trivial  nature  for 
which  it  is  not  worth  while  to  keep  any  special  ac- 
counts. Such  losses  and  gains  would  be  carried, 
whenever  they  occurred,  to  Profit  and  Loss,  and  there 
remain  to  be  combined  with  all  the  others  at  the  end 
of  the  year.  Obviously,  Profit  and  Loss  should,  in 
closing  the  business  at  the  end  of  the  year,  be  debited 
for  all  nominal  accounts  having  a  debit  balance  at 
that  time, — such,  for  instance,  as  wages,  rent  paid 
in  excess  of  that  earned,  interest  paid  in  excess  of 
that  earned,  commissions  paid  in  excess  of  that 
earned,  postage,    stationery,    etc.;  and    should    be 


102  ACCOUNTING  AND  AUDITING 

credited  by  the  earnings  from  merchandise,  interest 
when  earned  in  excess  of  allowances,  etc.  Profit  and 
Loss  may,  of  course,  show  the  balance  on  either  side. 
An  excess  of  credits  means  that  this  account  explains 
the  fact  that  our  assets  have  increased,  by  profits, 
over  what  they  were  at  the  beginning  of  the  period. 
Since  we  debit  property  accounts  and  credit  some  ex- 
planation account  (and  Profit  and  Loss  is  simply  the 
total  balance  of  all  explanation  accounts)  for  all 
profits  made  during  the  year,  the  balance  shown  to 
the  credit  of  this  account  at  the  end  of  the  year 
measures  the  increase  of  assets.  A  debit  balance  to 
Profit  and  Loss,  on  the  contrary,  indicates  net  shrink- 
age of  assets,  for  we  have  debited  some  explanation 
account  and  credited  some  property  account  for  all 
sums  disbursed  as  expenses  or  losses.  If  the  busi- 
ness is  a  corporation  and  suffers  a  loss  on  operations 
for  the  year.  Profit  and  Loss  will  remain  with  a  debit 
balance  at  the  end  of  the  year;  for  if  stockholders 
are  not  assessed  to  make  up  this  deficit,  there  is  no 
way  of  offsetting  this  loss  on  the  books  by  charg- 
ing it  against  any  other  account.  A  debit  balance, 
then,  means  simply  that  the  capital  of  the  corpora- 
tion has  been  depleted  by  the  amount  shown. 

So  far  we  have  been  considering  only  accounts 
which  are  of  practically  universal  use.  It  is  well  now 
to  observe  some  which,  though  common,  are  not 
necessarily  found  in  all  lines  of  business.  It  is  com- 
mon in  many  lines  of  business,  as  already  indicated, 
to  provide  that  when  bills  are  paid  early  a  discount 
may  be  subtracted  from  the  full  billed  price.  Some- 
times these  discounts  are  carried  directly  to  Mer- 
chandise; that  is,  if  the  discounts  are  taken  by  cus- 


THE  COMMON  LEDGER  ACCOUNTS  103 

tomers  on  goods  sold,  since  the  original  credit  to  Mer- 
chandise is  larger  than  the  amount  finally  paid,  Mer- 
chandise is  debited  for  the  amount  of  discount;  so 
that  the  net  result  is  the  same  as  if  Merchandise 
had  been  originally  credited  for  the  proper  figure. 
This  serves  the  purpose  very  well  in  most  particulars, 
but  it  does  not  indicate  what  is  the  actual  amount  of 
discount  allowed  in  the  course  of  the  year,  for  the 
figures  are  buried  in  Merchandise;  and  when  it  is  de- 
sirable to  compare  discounts  allowed  this  year  with 
those  allowed  last  year,  this  method  gives  no  in- 
formation. It  is  obvious,  of  course,  that  if  we  are 
selling  to  a  poorer  class  of  customers  this  year  than 
last  year,  they  probably  will  be  less  able  to  pay  their 
bills  promptly,  and  the  amount  of  discount  which 
they  take  will  be  smaller.  When  the  amount  of  goods 
sold  is  the  same,  therefore,  an  increase  in  the  amount 
of  discount  allowed  indicates  a  better  class  of  custom; 
and  as  this  figure  may  be  found  easily  only  when  dis- 
counts are  carried  to  an  account  which  contains 
nothing  else,  it  is  worth  while  to  keep  merchandise 
discounts  separate  during  the  year  and  carry  them 
at  the  end  of  the  year  into  Merchandise — as  a  final 
correction  of  prices, — or  directly  into  Profit  and  Loss. 
Another  method  of  accomplishing  the  same  end,  but 
on  a  more  scientific  basis,  will  be  discussed  later. 
The  method  described  here,  however,  is  the  common 
method  of  business. 

Another  special  account,  which  one  would  wish 
never  to  have  occasion  to  use,  is  for  bad  debts.  When 
it  is  finally  known  that  an  account  will  never  be  col- 
lected, though  from  one  point  of  view  it  is  still  de- 
sirable that  the  books  shall  show  that  the  money  is 


104  ACCOUNTING  AND  AUDITING 

owed,  from  another  point  of  view  it  is  desirable  to 
eliminate  the  account  altogether;  for  smns  due  to  the 
business  ought  to  be  counted  as  assets  in  calculating 
the  present  worth  of  the  business  at  the  end  of  the 
year.  If  bad  debts  are  allowed  to  remain  upon  the 
books,  there  is  great  danger  that  the  assets  will  ap- 
pear overstated.  A  method  of  keeping  record  of  the 
fact  that  the  debt  was  not  paid,  and  yet  of  removing 
the  accoimt  from  the  assets,  is  to  maintain  an  ac- 
count entitled  Bad  Debts.  Whenever  an  account  is 
known  to  be  bad  a  debit  is  made  to  Bad  Debts  and  a 
credit  to  the  account  concerned.  This  closes  the  bad 
account  and  leaves  Bad  Debts  with  a  balance  which 
is  of  the  nature  of  an  explanation  to  be  closed  into 
the  profit  and  loss  account  at  the  end  of  the  year.  If 
by  any  chance  the  debt  should  finally  be  paid,  en- 
tries may  be  made  to  indicate  the  fact  by  simply 
debiting  once  more  the  original  account  and  crediting 
Bad  Debts,  and  then  debiting  Cash  and  crediting  the 
original  account  for  the  amount  paid.  This  puts 
everything  where  it  would  have  been  if  the  account 
had  never  been  erroneously  thought  bad.  This  is 
better  than  crediting  Bad  Debts  directly  with  the 
cash,  for  then  the  original  account  still  looks  as  if  it 
had  never  been  paid*. 

A  similar  account  for  items  thought  possibly  to 
be  bad,  though  not  yet  abandoned,  is  sometimes  called 
Suspense.  To  this  account  are  debited  items  which 
the  proprietors  no  longer  wish  to  carry  as  good 
claims  and  yet  are  not  willing  to  charge  as  losses. 
The  method  of  handling  this  account  would  be  the 
same  as  that  for  Bad  Debts  except  that  at  the  end  of 
the  year  a  certain  percentage  of  such  accounts,  pos- 


THE  COMMOlSr  LEDGER  ACCOUNTS  105 

sibly  one-half,  one-third,  or  one-fourth,  would  be 
considered  as  good — on  the  assumption  not  so  much 
that  one-half  of  each  account  would  be  paid,  as  that 
an  amount  equivalent  to  one-half  of  the  total  would 
probably  be  paid  in  full. 

Sometimes  one  finds  in  bookkeeping  an  accoimt 
bearing  the  same  name  as  that  just  described,  but 
with  an  entirely  different  purpose.  If  it  is  a  little 
uncertain  at  a  time  money  is  spent  what  will  be  the 
ultimate  result  of  that  expenditure,  one  is  in  doubt 
what  to  debit.  Perhaps  the  company  is  engaged  in 
rebuilding  parts  of  its  plant,  and  it  is  not  sure  while 
the  work  is  in  progress  how  much  of  the  expendi- 
ture is  for  repairs,  which  ought  to  be  considered  as 
a  part  of  expenses,  and  how  much  is  for  actual  ad- 
ditions, which  ought  to  be  charged  to  Real  Estate. 
By  the  device  of  a  suspense  account,  to  which  all 
such  expenses  may  be  temporarily  charged,  it  is  pos- 
sible to  postpone  the  final  decision  as  to  the  amounts 
to  be  charged  to  Repairs  and  to  Real  Estate  until  the 
work  is  completed.  Then  an  entry  debiting  Real 
Estate  and  Repairs  and  crediting  Suspense  will  rep- 
resent the  facts  properly  upon  the  books. 

An  entirely  new  class  of  accounts  unlike  any  we 
have  been  discussing  up  to  this  point  are  so-called 
reserve  accounts.  It  is  obvious  that  if,  at  the  end 
of  the  year.  Profit  and  Loss  shows  a  balance  on  the 
credit^  side,  the  business  has  earned  something  dur- 
ing the  year  in  excess  of  its  expenses.  If  all  this 
credit  balance  is  distributed  as  dividends.  Profit  and 
Loss  will  have  no  balance  at  the  beginning  of  the  new 
year;  for  on  the  distribution  of  dividends  Profit  and 
Loss  will  be  debited  and  Cash  will  be  credited.   If,  on 


106  ACCOUNTING  AND  AUDITING 

the  other  hand,  the  directors  or  partners  decide  not 
to  distribute  all  the  earnings  as  dividends,  Profit  and 
Loss  will  have  a  balance  representing  undivided 
profits.  Several  dispositions  of  these  undivided 
profits  are  possible.  It  is  common  to  leave  them 
standing  just  as  they  are  on  the  ledger.  When  left 
in  this  fashion,  it  is  of  course  possible  that  they  may 
be  distributed  in  another  year,  for  it  may  chance  that 
the  later  earnings  are  a  little  less  than  in  the  past 
and  the  surplus  earnings  accumulated  may  be  used 
to  make  up  the  dividend  to  an  amount  as  large  as  that 
previously  distributed.  If,  on  the  other  hand,  it  is 
the  policy  of  the  managers  to  keep  out  of  each  year's 
profits  a  certain  portion  as  a  safety  fund  for  possible 
losses  through  bad  debts,  through  depreciation  of  ma- 
chinery, through  changes  of  fashion — ^throwing  out 
of  use  goods  and  machinery  to  make  such  goods, — it 
may  be  desirable  to  label,  so  to  speak,  a  certain  part 
of  the  accumulated  profits  so  that  they  shall  be  under- 
stood as  intended  to  be  maintained  unimpaired  in  the 
business  and  never,  or  at  least  not  for  some  years, 
distributed  as  dividends.  The  way  to  accomplish  this 
on  the  books  is  to  make  an  entry  debiting  Profit  and 
Loss  and  crediting  a  special  account  (that  is,  simply 
transferring  the  balance),  and  thus  to  convert  the  old 
profit  and  loss  balance  into  a  new  profit  and  loss 
balance  which  appears  on  the  books  with  a  name  in- 
dicating its  specific  purpose, — such  as  Permanent 
Surplus.  In  such  cases  it  is  clear  that,  just  as  Profit 
and  Loss  is  a  nominal  account  explaining  that  a  cer- 
tain amount  of  the  assets  of  the  business  has  come 
from  profit-yielding  operations,  so  the  reserve  ac- 
count is  nominal  and  indicates  that  a  certain  amount 


THE  COMMON  LEDGER  ACCOUNTS  107 

of  assets,  consisting  of  accumulated  profits,  is  in- 
tended for  a  specific  purpose  other  than  distribution 
as  dividends.  A  large  business  may  maintain  several 
different  reserve  accounts  of  the  sort  described.  For 
instance,  it  may  have  so  many  buildings  and  so  much 
machinery  scattered  about  in  many  places  that  the 
managers  believe  it  can  more  cheaply  get  along  with- 
out fire  insurance  and  run  the  risk  of  fire  losses  than 
pay  insurance  to  insurance  companies.  In  that  case, 
the  part  of  wisdom  would  be  to  set  apart  out  of  each 
year's  apparent  profits  a  certain  reserve  to  cover 
the  possibility  of  loss  by  fire.  If  the  company  has 
good  luck,  this  reserve  will  be  constantly  growing  and 
will  represent  earnings  found  to  be  unnecessary  for 
replacement  of  buildings.  If  in  any  year  a  fire  oc- 
curs, this  account  will  be  debited  for  the  amount  re- 
quired to  replace  the  buildings  destroyed.  Again,  it 
is  a  common  thing  for  machinery  to  become  out  of 
date  by  the  discovery  of  new  processes  which  will 
produce  goods  more  cheaply  than  the  old  machinery 
can  do.  Many  companies,  to  protect  themselves 
against  loss  through  the  occurrence  of  this  sort  of 
thing,  establish  regularly  a  reserve  for  obsolescence 
of  machinery.  This  appears,  of  course,  as  a  credit  on 
the  books — a  specially  labeled  profit  and  loss  credit 
balance. 


CHAPTER  V     , 

THE  PRACTICAL  OPERATIONS  OF  BOOKKEEPING 

We  saw  in  the  last  chapter  a  good  many  illustra- 
tions of  the  method  of  making  entries  through  the 
journal,  and  we  saw  in  the  preceding  chapter  that, 
by  means  of  books  which  are  specialized  forms  of  the 
journal,  we  may  post  certain  common  items,  like  cash 
and  merchandise,  in  totals  at  the  end  of  each  month 
or  week  instead  of  individually,  item  by  item.  Let 
us  review  these  special  books  and  then  examine  the 
actual  methods  of  dealing  with  them. 

When  we  use  a  cash  book  and  one  page  is  made  to 
include  all  the  debits  to  Cash — with,  of  course,  credits 
to  other  accounts, — and  the  other  page  to  include 
credits  to  Cash — with  debits  to  other  accounts,  any 
number  of  items  may  be  posted  as  a  debit  or  a  credit 
to  Cash  in  one  lump  sum,  and  so  the  total  nimaber  of 
postings  for  each  side  of  the  book  is  only  one  greater 
than  the  number  of  items.  If,  for  instance,  there  are 
one  hundred  items  of  Cash  receipts,  there  will  be 
one  hundred  credits  to  the  accounts  representing  the 
source  of  the  cash,  and  there  will  be  only  one  debit 
to  Cash — which  is  a  total  of  all  the  receipts;  and  the 
one  debit  to  Cash  will  be  the  amount  of  the  credits 
to  all  the  other  accounts.  However  great  the  number 
of  items,  if  we  can  keep  all  our  Cash  debits  in  one 
place,  we  need  only  one  Cash  debit  to  offset  all  the 

109 


110  ACCOUNTING  AND  AUDITING 

credit  items.  The  same  thing  is  true  on  the  other  side 
of  the  cash  book,  on  the  purchase  book,  and  on  the 
sales  book.  So,  although  we  started  with  a  consid- 
eration of  the  only  proper  bookkeeping  method  as 
that  of  double  entry,  we  have  found  that  the  double 
entry  is  double  not  in  the  sense  that  it  requires  two 
entries  or  even  two  postings  for  each  transaction,  but 
only  in  the  sense  that  it  has  debits  equal  to  credits. 

It  is  well  to  note  a  number  of  things  with  regard 
to  the  manner  of  making  postings  to  the  ledger.  It  is 
desirable,  of  course,  to  indicate  on  the  book  of  original 
entry  whenever  a  posting  has  been  made,  for  other- 
wise an  unintentional  second  posting  of  the  amount 
might  throw  the  ledger  out  of  accord  with  the  facts. 
The  usual  method  of  indicating  the  fact  that  the  work 
has  been  done  is  to  make  a  check  mark;  but  since 
there  is  advantage  in  having  in  the  journal  a  record 
of  the  page  of  the  ledger  to  which  the  posting  was 
made  (in  order  that  in  looking  the  matter  up  again 
one  may  turn  to  it  readily),  the  number  of  the  ledger 
page,  or  ^ ledger  folio,"  is  commonly  used  as  the 
check  mark.  Similarly,  in  the  ledger  it  is  desirable  to 
have  for  reference  an  indication  of  the  page  from 
which  the  entry  came,  and  in  ledger  rulings  a  column 
is  provided  for  that  purpose.  Care  should  be  taken 
in  making  postings  that,  even  though  the  bookkeeper 
knows  the  number  of  the  ledger  folio  to  which  he  will 
transfer  the  item,  he  does  not  write  that  number  in 
the  column  for  check  marks  until  after  the  posting 
is  actually  made;  for  otherwise,  if  by  any  chance  he 
is  interrupted  in  the  process,  the  check  mark  may 
mislead  him  and  possibly  the  item  will  not  get  upon 


PRACTICAL  OPEEATIONS  OF  BOOKKEEPING     111 

the  ledger  until  after  a  long  search  in  quest  of  the  un- 
known error. 

Now  that  we  have  our  original  entries  cut  up  and 
distributed  among  four  books,  we  may  find  oc- 
casionally that  various  parts  of  what  is  really  one 
transaction  must  be  split  among  several  books.  It  is 
a  convenience  to  have  all  items  belonging  to  one 
transaction  in  one  place.  If  that  convenience  is  very 
great,  it  may  be  worth  while  to  make  the  full  entry  in 
the  journal,  even  though  cash  be  involved,  and  then 
make  another  entry  in  the  cash  book  in  order  that 
the  amount  of  cash  may  appear  among  the  cash  re- 
ceipts. When  this  is  done,  unless  a  precaution  is 
taken.  Cash  will  be  debited  or  credited  twice — once 
in  the  journal  and  once  in  the  cash  book.  It  is  easy 
to  head  off  a  second  posting  by  checking  this  cash 
item  in  the  journal  at  the  time  the  entry  is  made. 
If  the  check  used  is  a  blank  check,  instead  of  the  folio 
number,  this  check  will  indicate  that  posting  has  not 
been  made  and  need  not  be  made  from  this  place  and 
that  the  entry  appears  elsewhere  and  will  be  posted 
thence.  Any  entries  may  be  introduced  into  any  book, 
for  the  sake  of  a  comprehensive  statement  of  the 
transaction — even  though  duplicate  entries  are  made 
in  other  books, — provided  only  the  blank  check  13 
used  to  head  off  duplicate  postings.  This  principle 
may  be  well  illustrated  by  one  treatment  of  a  cash 
sale.  Some  houses  use  a  special  cash-sales  book,  from 
which  the  total  is  carried  to  the  cash  book  as  a  debit 
to  Cash  and  a  credit  to  Merchandise.  The  credit  post- 
ing to  Merchandise  may  then  be  made,  obviously, 
either  from  the  cash  book,  to  which  the  total  is  trans- 
ferred, or  directly  from  the  footing  of  the  cash-sales 


112  ACCOUNTIN^G  AND  AUDITING 

book  itself.  Even  when  this  special  sales  book  for 
cash  sales  is  not  provided,  however,  it  is  desirable 
that  the  entry  shall  be  made  on  the  cash  book  in  order 
that  all  cash  items  may  be  together,  and  it  is  desirable 
that  it  shall  be  also  upon  the  sales  book  in  order  that 
we  may  have  a  complete  record  of  sales.  Unless  we 
take  precaution  to  head  off  the  possible  double  post- 
ing— that  is,  both  the  debit  to  Cash  and  credit  to  Mer- 
chandise from  the  cash  book  and  the  credit  to  Mer- 
chandise and  debit  to  Cash  from  the  sales  book, — we 
shall  have  both  of  these  accounts  thrown  out  of  ac- 
cord with  the  facts.  If,  however,  we  make  in  both 
books,  at  the  time  of  entry,  the  blank  check  in  the 
check  column,  we  provide  that  Cash  shall  be  prop- 
erly debited,  because  the  amount  will  be  included  in 
the  footing  of  the  page  as  a  Cash  debit  for  the  period, 
and  that  Merchandise  shall  be  properly  credited,  be- 
cause the  sale  will  be  included  in  the  footing  of  the 
sales  book  for  the  period;  but  since  both  items  are 
checked.  Merchandise  is  not  improperly  credited 
again  from  the  cash  book  (as  it  naturally  would  be 
if  not  checked),  and  Cash  is  not  improperly  debited 
again  from  the  sales  book  (as  it  naturally  would  be 
if  not  checked) .  This  is  shown  on  pages  122  and  125 
for  the  sale  to  George  Berkeley  on  January  17.  The 
item  is  checked  in  both  sales  book  and  cash  book. 
Cash  gets  a  debit  posting  through  the  total  for  the 
month  on  the  cash  book,  and  Merchandise  gets  a 
credit  posting  through  the  total  sales  on  the  sales 
book.  A  large  number  of  uses  of  the  blank  check 
may  be  worth  while  in  such  connections  as  this.  We 
might,  for  instance,  give  Laurence  Sterne  credit  on 
the  journal  (page  121)   for  his  whole  investment, 


MACTICAL  OPEEATIOKS  OF  BOOKKEEPING     113 

including  cash;  then  if  we  check  the  cash  item  in 
the  journal  and  check  the  Laurence  Sterne  item  in 
the  cash  book  (page  122),  all  will  be  as  it  should  be. 
This  is  not  done,  however,  for  there  is  no  objection  to 
splitting  the  item  between  two  books. 

It  is  not  necessary  to  add  the  columns  of  the  jour- 
nal, for  the  totals  are  not  to  be  posted  to  any  account. 
When  it  happens,  however,  that  the  separate  items 
of  debits  and  of  credits  are  not  identical,  it  may  be 
worth  while  to  add  the  journal  columns  in  order  to 
make  sure  that  the  total  debits  equal  the  total  credits, 
— which  of  course  they  ought  to  do.  If,  that  is  to 
say,  many  entries  are  so  complicated,  like  that  on 
page  70,  that,  though  the  sum  of  the  debits  equals 
the  sum  of  the  credits,  the  debits  and  the  credits  are 
not  identical  item  for  item,  one  cannot  at  a  glance 
make  sure  that  the  total  debits  equal  the  total  credits 
unless  one  takes  the  footings  of  the  columns  and 
compares  them.  To  test  a  page  made  up  of  such 
items  and  to  preserve  the  test  by  entering  the  totals 
in  the  journal,  as  a  footing  of  the  page,  gives  satis- 
faction not  only  to  the  bookkeeper  but  to  anyone  who 
has  occasion  to  use  the  book.  Such  a  total  is  shown 
on  page  121. 

We  may  note  next  that  the  custom  has  grown  up 
in  bookkeeping  of  making  occasional  entries  which 
are  distinctly  false,  but  those  entries  are  accompa- 
nied by  other  entries  which  offset  the  intentional 
error.  The  best  illustration  of  this  is  on  the  cash 
book  when  discounts  are  allowed.  The  method  is  the 
same  whether  the  discounts  are  those  similar  to  in- 
terest, such  as  we  had  in  the  transactions  worked 

out  in  detail  in  the  last  chapter,  or  are  commercial 
A  &  A-8  ■; 


U4  ACCOIJNTING  AND  AtJDITIK& 

discounts  allowed  for  early  payment  of  bills.  It  is 
obvious  that  when  we  discount  a  note  at  a  bank  and 
receive  the  face  of  the  note  less  the  discount,  the 
transaction  is  quite  the  same  as  if  the  bank  gave  us 
the  face  value  of  the  note  and  then  required  us  to 
pay  the  discount  in  cash.  To  make  an  entry  as  if 
that  took  place,  then,  is  not  essentially  to  falsify  the 
record.  If  that  actually  happened  we  should  on  the 
credit  or  disbursement  side  of  the  cash  book  enter  a 
debit  to  Discount;  that  is,  we  should  enter  on  the 
credit  side  of  the  cash  book  the  item  '* Discount," 
and  this,  of  course,  appearing  on  that  side  of  the 
cash  book  means  that  Discount  is  debited.  We 
should  at  the  same  time  on  the  debit  or  receipts  side 
of  the  cash  book  enter  ''Bills  Payable"  at  the  full 
face  of  the  note,  and  this  appearing  on  that  side  of 
the  book  is  necessarily  a  credit  to  BiUs  Payable.- 
When  these  items  have  been  posted,  each  account  has 
its  proper  balance  of  debit  and  credit;  and  the  only 
falsification  lies  in  an  overstatement  of  the  total 
amount  of  cash  handled:  for  the  receipts  side  of  the 
cash  book  shows  a  sum  larger  than  was  actually  re- 
ceived (by  the  amount  of  the  discount)  because  we 
have  debited  Cash  for  the  full  face  of  the  note  though 
we  have  received  less  than  that  sum,  and  the  dis- 
bursements side  of  the  book  shows  a  sum  including 
the  amount  of  the  discount,  though  no  cash  was  paid 
out  on  that  score.  This  exaggeration  of  the  amount 
of  receipts  and  of  disbursements  does  no  harm,  how- 
ever, for  since  both  sides  are  exaggerated  alike  the 
balance  between  them  is  accurate.  This  device  saves 
the  labor  of  splitting  such  entries  between  two  books^. 
for  without  it  the  discounts  would  have  to  go  upon 


PEACTICAL  OPERATIONS  OF  BOOKKEEPING    llS 

the  journal.  It  is  illustrated  on  pages  122  and  123 
in  the  discounts  for  January  10,  12  and  27. 

Bookkeeping  recognizes  no  such  thing  as  sub- 
traction. It  would  be  extremely  awkward  if  it  were 
necessary  to  indicate  in  any  place  that  a  certain 
figure  were  to  be  subtracted  from  the  figure  above 
it,  for  then  totals  could  not  be  taken  without  con- 
stant precaution  that  a  sum  to  be  subtracted  were 
not  added.  It  is  often  necessary,  however,  to  pro- 
duce the  effect  of  a  subtraction.  This  is  alwavs  done 
by  adding  to  the  other  side  of  an  account  the  figures 
to  be  subtracted.  Suppose  an  account  shows  a  total 
of  $5,000  on  the  credit  side,  and  $4,000  on  the  debit 
side.  Subtraction  gives  us  a  balance  of  $1,000  credit. 
If  we  were  to  subtract  that  $1,000  and  bring  down 
our  $4,000,  we  could  then  rule  up  the  account  as  bal- 
anced and  carry  the  balance  down  to  the  re-opening 
of  the  account.  The  same  result  is  produced  by 
adding  $1,000  on  the  debit  side  (for  this  gives  $5,000 
on  each  side — which  produces  an  equality),  and  then 
bringing  down  the  $1,000  as  the  new  balance  on  the 
credit  side.  Such  artificial  insertions  are  usually 
made  in  red  ink;  for  they  thus  call  conspicuously  to 
the  attention  of  anyone  reading  the  account  the  fact 
that  the  item  is  not  a  proper  debit  due  to  some  re- 
sponsibility assumed,  but  is  artificially  inserted 
merely  to  measure  the  excess  of  the  other  side.  It  is 
obvious  that  one  may  as  well  compare  two  things  by 
adding  to  the  smaller  and  seeing  how  much  is  re- 
quired to  make  them  equal,  as  by  subtracting  from 
the  larger.  The  common  method  of  balancing  is  just 
that:  we  see  how  big  a  thing  is  required  to  bring  the 
small  side  up  to  a  level  with  the  large,  and  we  insert 


116  ACCOlTNTmG  AND  AUDITINa 

it  in  red  ink  to  call  attention  to  the  fact  that  it  is  only 
the  rneasure  of  the  excess  on  the  other  side.  Indeed, 
this  is  what  we  commonly  do  in  comparing  things 
with  a  yard  stick.  We  measure  the  long  and  then 
the  short,  and  see  how  large  a  piece  would  need  to  be 
added  to  the  short  piece  to  make  up  the  length  of  the 
long.  It  is  true,  then,  that  the  amount  brought  down 
on  re-opening  the  account  is  not  really  the  amount 
written  in  red  ink  on  the  other  side.  What  we  bring 
down  is  simply  the  excess  on  the  big  side,  and  it 
chances  that  the  size  of  that  excess  is  measured  by 
the  item  written  in  red  on  the  short  side.  As  a  work- 
ing rule,  however,  we  may  say  that  an  item  written 
in  red  is  always  brought  down  on  the  other  side, — 
but  the  reason  is  that  the  item  simply  measures  an 
excess  on  the  same  side.  This  method  is  illustrated 
in  the  form  of  cash  book  shown  on  page  123.  The 
same  method  is  used  in  balancing  a  ledger. 

In  a  cash  book  the  item  of  balances  is  usually  the 
only  item  which  is  not  to  be  posted.  A  bookkeeper 
in  running  his  eye  up  the  column  reserved  for  check 
marks,  to  see  that  no  posting  has  been  omitted,  ob- 
serves the  blank  space  and  has  his  attention  arrested. 
He  must  look  to  see  why  the  omission  occurs.  It  is 
a  convenience,  therefore,  to  have  a  check  in  that 
column  to  satisfy  the  eye  that  the  work  is  finished; 
at  the  same  time  it  is  worth  while  to  use  that  check 
as  an  indication  that  the  bookkeeper  has  looked  to  see 
that  the  balance  brought  down  or  carried  over  is  the 
same  as  that  inserted  in  closing;  and  this  observa- 
tion he  should  always  make  before  putting  the  check 
mark  into  the  column.  As  illustrated  on  pages  123 
and  122,  the  last  item  on  the  credit  side,  $2,894.65, 


PKACTICAL  OPEEATIONS  OF  BOOKKEEPING     117 

which  is  the  closing  balance,  is  checked  with  the 
February  1  opening  balance  on  the  debit  side. 

In  modern  practice  it  is  common  in  posting  to 
omit  from  the  ledger  everything  except  the  date,  the 
page  nmnber  of  the  book  of  original  entry  from 
which  the  item  is  taken,  and  the  amount.  This  has 
the  advantage  of  reducing  labor  to  a  minimum,  but 
there  is  a  corresponding  disadvantage  lying  in  the 
fact  that  there  is  nothing  to  indicate  in  the  posting 
just  what  is  the  nature  of  the  transaction;  and  there- 
fore it  may  be  necessary  often  to  look  back  to  origi- 
nal entries  to  see  what  happened.  Even  a  slight  in- 
dication of  what  happened  will  usually  sufl&ce  as  a 
reminder  of  all  that  it  is  necessary  for  ordinary  pur- 
poses to  know,  and  this  can  be  easily  given  by  a  men- 
tion of  the  other  account  concerned.  If,  then,  in 
posting  we  always  indicate  in  the  ledger  the  name  of 
that  other  account,  such,  for  instance,  as  what  was 
debited  when  Bills  Payable  (page  79)  was  cred- 
ited, we  have  in  the  ledger  a  complete  summary  of 
each  transaction.  To  do  this,  moreover,  is  not  a  seri- 
ous task,  for  in  books  developed  as  most  books  are 
nowadays  it  is  likely  to  happen  that  most  credits 
to  any  account  will  be  of  the  same  nature — for  in- 
stance, Merchandise  or  Cash  or  Notes, — and,  there- 
fore, after  the  name  of  the  other  account  has  once 
been  written  its  duplication  is  indicated  by  simple 
ditto  marks.  The  labor  is  inconsiderable,  and  then  if 
any  item  of  an  unusual  sort  occurs  it  will  be  written 
in  full  in  the  ledger  and  will  catch  the  eye  readily  if 
it  is  ever  sought. 

We  have  so  far  been  concerned  only  with  what 
are  called  the  *^ principal  books,"    The  work  of 


118  ACCOUNTING  AND  AUDITING 

making  and  of  finding  desired  records  may  be  very 
much  reduced  if  we  keep  certain  memoranda  in  aux- 
iliary books.  These  may  not  only  relieve  the  prin- 
cipal books  of  a  great  burden  of  detail,  but  may  show 
the  information  in  a  tabulated  form  convenient  for 
reference.  A  good  illustration  of  such  auxiliary 
books  is  the  so-called  ^^bill  book/'  in  which  are 
usually  kept  lists  of  all  bills  receivable  and  bills  pay- 
able. A  separate  book,  or  portion  of  a  book,  is  kept 
for  each  of  these.  The  form  of  each  of  these  books 
supplies  a  large  number  of  columns  for  a  complete 
record  of  all  details  concerning  each  note, — such,  for 
instance,  as  the  maker,  the  indorsers,  the  date,  the 
time  to  run,  the  rate  of  interest,  where  the  note  is 
payable,  its  maturity,  and  the  amount.  Usually  a 
dozen  columns,  one  for  each  month,  are  provided  for 
the  date  of  maturity,  so  that  it  is  necessary  to  write 
only  the  day  of  the  month  in  the  column  for  the 
month.  This  is  a  great  convenience,  for  since  notes 
mature  usually  not  in  the  order  of  acquisition  (be- 
cause of  different  duration),  it  is  something  of  a  task, 
where  there  are  many  notes,  to  go  through  the 
list  and  pick  out,  without  risk  of  error,  all  maturing 
on  any  particular  day.  If  carelessness  occurs,  some 
notes  fail  of  presentation  or  of  payment  at  the  proper 
time.  When,  however,  a  column  is  provided  for 
each  month  of  the  year,  and  those  notes  maturing  in 
each  month  are  indicated  by  numerals  on  the  proper 
line  and  in  the  proper  column,  one  can  at  a  glance 
see  just  what  are  coming  to  maturity  in  each  month. 
If  in  a  bill  book  all  notes  received  and  all  notes  is- 
sued are  given  artificial  numbers  in  consecutive 
order,  reference  to  them  in  the  principal  books — for 


PEACTICAL  OPERATIONS  OF  BOOKKEEPING     119 

instance,  the  joiu-nal  when  they  are  received  and  the 
cash  book  when  they  are  paid — ^may  be  made  by 
simply  mentioning  the  nmnbers  with  the  addition  of 
**B.E."  or  *'B.P."  to  indicate  whether  the  notes  are 
bills  receivable  or  bills  payable.  Then,  if  at  any  time 
one  wishes  to  trace  one  of  these  notes  or  identify  it, 
all  the  facts  can  be  learned  from  the  bill  book.  Thus, 
on  the  cash  book,  **B.  R.  No.  17  paid"  is  all  the  ex- 
planation necessary  on  the  payment  of  the  note 
bearing  that  number. 

A  similar  arrangement  is  commonly  provided  for 
what  are  called  ** accounts  payable,''  that  is,  sums  due 
to  creditors.  Since  commonly  discounts  are  offered 
for  early  payment  of  bills,  it  is  a  matter  of  much 
importance  that  no  bill  be  allowed  to  run  over  the 
date  of  the  highest  rate  of  discount  Sometimes  the 
rates  run  as  high  as  seven  or  eight  per  cent,  discount 
in  case  the  bill  is  paid  in  ten  days.  This  is  too  large 
an  item  to  be  neglected,  and,  consequently,  every  pre- 
caution should  be  taken  that  such  a  bill  be  not  for- 
gotten. For  an  accounts  payable  book,  therefore, 
there  may  be  wisely  provided  not  only  a  column  for 
each  month  in  the  year,  so  that  maturities  may  be 
easily  indicated  opposite  each  bill,  but  even  two, 
three,  or  f  oin*  such  columns  to  cover  smaller  intervals 
of  time.  If  two  columns  are  provided  for  each 
month,  one  will  be  headed  **1 — 15,"  and  the  other, 
**16 — 31;"  if  three  columns  are  provided,  the  first 
will  read  **1— 10,"  the  second,  ^^11— 20,"  the  third, 
**21 — 31;"  if  four  are  provided,  the  first  will  read 
'^1— 7,"  the  second,  *^8— 15,"  the  third,  ^^16—23," 
the  fourth,  **24 — 31."  The  same  sort  of  thing  may 
be  desirable  for  accounts  receivable,  that  is,  sums  due 


120  ACCOUNTING  AND  AUDITING 

from  customers,  though  the  need  is  not  quite  so  great 
in  this  case,  for  there  is  less  likelihood  of  loss  of 
money  by  the  neglect  to  know  each  day  what  bills 
are  maturing  at  that  time.  The  maturity  columns 
in  this  book  are  serviceable  mainly  as  a  means  of 
watching  customers'  accounts  and  following  them  up 
if  bills  are  not  paid  promptly. 

We  will  now  see  how  the  transactions  worked  out 
in  detail  during  the  discussion  of  the  preceding  chap- 
ter would  be  recorded  under  a  system  of  bookkeeping 
which  utilizes  not  only  a  journal,  but  also  a  cash  book, 
a  purchase  book,  and  a  sales  book.  [The  reader  who 
wishes  to  understand  clearly  the  use  of  these  books 
is  recommended  to  turn  back  to  these  transactions, 
beginning  on  page  70  and,  taking  them  one  by  one, 
make  up  his  mind  for  each  in  what  book  it  should  be 
entered  and  in  just  what  form.  Then  he  should 
examine  the  form  given  in  the  following  pages.] 


PEACTICAL  OPERATIONS  OF  BOOKKEEPING     121 


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124 


ACCOUNTING  AND  AUDITING 


80 


82 
83 
V 
80 
25 


Charles  Dickens 

100  doz.  No.  62 
200    ''     No.  57 


[PUECHA8E  BOOK] 
Jan.  2 

10  days 


14.00 
13.00 


Cash  (Charles  Keade) 

[Details  should  be  shown  as  above  or 
by  invoice  number] 
5 
Alexander  Pope  Cash 

[Details] 

9 
Walter  Scott  10  days 

[Details] 

11 
Cash  (John  Dryden) 

[Details] 

30 
Charles  Dickens  10  days, 

[Details] 

31 

Merchandise,  Dr.  Total  for  month 


140000 
260000 


[Page  1 

400000 

300000 
600000 
700000 

600000 
100000 


2700000 


[The  transaction  for  January  2  is  exactly  like 
that  for  January  5,  and  yet  the  two  are  treated  differ- 
ently. The  difference  is  due  to  the  fact  that  we  wish 
the  Pope  sale  to  go  upon  the  ledger,  but  do  not  care 
to  distinguish  the.  Reade  sale  from  other  miscel- 
laneous sales.] 


PRACTICAL  OPERATIONS  OP  BOOKKEEPING    125 


81 

84 
85 


[SALES   BOOK] 
Jan.  5 


Anthony  TroUope 

50  doz.  No.  65 


13 


Jonathan  Swift 

[Details  should  be  shown] 
15 
Richard  'Steele 

[Details] 


30  days 
14.00 

10  days 
10  days 


Bills  Beceivable 
[Details] 


Cash 


Cash 


[Details] 


[Details] 


Jonathan  Swift 
[Details] 

Richard  Steele 
[Details] 


16 
17 
24 
30 
30 
31 


(Joseph  Addison) 
(George  Berkeley) 

(Henry  Fielding) 
30  days 
30  days 


Merchandise,  Cr.    Total  for  month 


[Pagk  1 

70000 
57500 
20000 
60000 
30000 
120000 
50000 
50000 


457500 


Let  us  now  examine  the  posting  of  these  items. 
[The  reader  wishing  to  understand  the  method  in 
detail  is  recommended  to  take  the  items  one  by  one, 
as  given  in  the  books  of  original  entry,  pages  121- 
125,  and  make  up  his  mind  for  each,  before  looking 
at  the  ledger  form  given,  just  what  should  be  written 
in  each  column  of  the  ledger.] 


126 


ACCOUI^TING  AND  AUDITIM 


LAURENCE  STERNE 

[Pagel 

Jan.  25 

Cash 

2 

75 

00 

Jan.   1 

Sundries 

1 

10993 

75 

29 

2 

150 

00 

Cash 

1 

15000 

00 

CASH 


[Page  5 


Jan.  31      Sundries 


31092  25      Jan.  31  Sundries 


28197  60 


BILLS  RECEIVABLE 


[Page  8 


Jan.  1 

Sundries 

1 

16 

Merchandise 

1 

26 

Anthony  Trollope 

1 

5000  00 

Jan.  10 

600  00 

12 

700  00 

16 

27 

Cash 


1500 
2000 
500 
700 


BILLS  PAYABLE 


[Page  12 


Jan.  12  Cash 


4000  00 


Jan.   9 
10 

18 


Charles  Dickens 
Cash 


4000 
5000 
4000 


Sundries 
Cash 


REAL  ESTATE 


[Page  16 


Jan.   1 
22 


15000 
300 


INTEREST 

[Page  18 

Jan.  10 

Cash 

2 

25 

00 

Jan.   1 

Sundries 

1 

6 

25 

12 

2 

6 

67 

10 

Cash 

1 

17 

25 

27 

2 

93 

RENT 


[Page  22 


Jan.  22  Cash 


100  00 


MERCHANDISE 


[Page  25 


Jan.  31  Sundries 


1  27000  00  f  Jan.  31  Sundries 


4575  00 


EXPENSE 


[Page  30 


Jan.   4  Cash 


2  25  00 


I>1ACTICAL  OPERATIONS  OF  B00K:KEEHK'G  WH 


FURNITURE  AND  FIXTURES 

[Page  15 

Jan.  1 

Cash 

2 

500 

00 

POSTAGE                                                     [P»«8  M 

Jan.   1 

Cash 

2 

15 

00 

STATIONERY                                                 [Page  41 

Jan.   1 

Cash 

2 

125 

00 

FREIGHT                                                    [Pa«e  44 

Jan.    3 

Cash 

' 

65 

00 

DELIYERY  EQUIPMENT                                     [Page  M 

Jan.    4 

Cash 

2 

500 

00 

ADVERTISING                                             [Page  50 

Jan.    4 

Cash 

2 

30 

90 

1 

WAGES                                                     [Page  52 

Jam.    S 

Cash 

2 

80 

00 

INSURANCE                                                 [Page  58 

Jan.  19 

Cash 

2 

100 

00 

FUEL                                                       [Page  58 

JaB.  2% 

Cash 

2 

100 

00 

ns 


ACCOUNTING  AND  AUDITING 


PROPl 

T  AND  LOSS 

[Page  60 , 

Jan.  24 

Cash 

2 

100 

00 

i 

CHARLES  DICKENS 

[Page  80 

Jan.    9 

Bills  Payable 

1 

4000 

00 

Jan.    2 
30 

Merchandise 

} 

4000 
1000 

00 
00 

ANTHONY  TROLLOPE 

[Page  81 

Jan.    5 

Merchandise 

1 

700 

00 

Jan.  26 

Bills  Receivable 

1 

700 

00 

ALEXANDER  POPE 

[Page  82 

Jan.    5 

Cash 

2 

6000 

00 

Jan.    5 

Merchandise 

1 

6000 

0 

WALTER  SCOTT 

[Page  83 

Jan.  IS 

Cash 

2 

7000 

00 

Jan.    9 

Merchandise 

1 

7000 

00 

JONATHAN  SWIFT 

[Page  84 

Jan.  13 
80 

Merchandise 

1 
1 

575 
600 

00 
00 

Jan.  23 

Cash 

1 

575 

00 

RICHARD  STEELE 

[Page  85 

j„.« 

Merchandise 

1 
1 

200 

500 

00 
00 

Jan.  25 

Cash 

1 

200 

00 

We  have  seen  that  it  is  possible  to  have  any  num- 
ber of  debits  to  Cash  with  only  one  posting  to  Cash. 
It  can  readily  be  seen  that  if  we  provide  a  special 
column  in  the  cash  book  and  into  this  carry  all  items 
belonging  to  any  one  account  which  needs  to  be  cred- 
ited when  Cash  is  debited,  we  can  post  all  those 


PKACTICAL  OPEEATIONS  OF  BOOKKEEPING     129 

credits  in  one  lump  sum  quite  as  easily  as  we  post  the 
Cash  debits.  It  often  chances  that  a  business  is  of 
such  a  nature  that  a  large  portion  of  the  receipts  or 
of  the  expenditures  are  of  the  same  sort.  A  column 
provided  for  the  account  concerned  makes  it  possible 
to  reduce  to  a  minimum  the  total  number  of  postings 
for  all  transactions.  Let  us  suppose,  for  instance, 
that  of  the  cash  expenditures  one-half  are  chargeable 
to  Expense.  If  we  provide  a  special  column  for  ex- 
penses so  that  all  expense  items  shall  be  carried  into 
that  column  and  all  other  items  into  the  principal 
column,  we  may  then  neglect  the  posting  of  all  ex- 
pense items  until  the  end  of  the  month.  They  have 
been  ''laid  on  the  table,"  so  to  speak.  The  items 
extended  into  the  general  column  will  be  posted  to 
the  ledger  in  the  usual  fashion,  item  by  item;  that  is, 
the  first,  perhaps,  to  Bills  Payable,  the  next  to  one  of 
our  creditors  whom  we  have  paid,  the  next  to  Freight, 
the  next  to  Stationery.  Then  if  at  the  end  of  the 
month  we  post  the  total  of  the  special  expense  col- 
umn to  Expense,  and  carry  that  total  into  the  general 
column  so  that  it  is  included  in  the  total  credit  to 
Cash,  we  have  produced  the  desired  result  upon  our 
ledger.  We  simply  hold  up  the  expense  postings 
through  the  medium  of  a  special  column  until  the  end 
of  the  month  and  then  take  them  in  a  lump  sum.  So 
far  as  our  cash  expenditures  are  for  expense,  we  are 
by  the  device  of  the  special  (expense)  column  in  the 
special  (cash)  book  providing  that  neither  half  of  the 
entry — that  is,  neither  Cash  nor  Expense — need  be 
posted  oftener  than  at  convenient  intervals,  and  then 
only  in  lump  sums.  One  posting  for  Expense  and  one 
posting  for  Cash  does  all  the  work  even  though  there 

A  &  A-9 


ISO  ACCOUNTING  AND  AUDITING 

be  five  hundred  sucli  items.  If,  again,  we  assume 
that  of  the  remaining  cash  expenditures  one-half  are 
for  freight,  and  a  special  column  is  provided  for 
Freight,  to  be  treated  similarly  to  that  for  Expense, 
we  have  reduced  to  one-fourth  the  items  which  must 
be  posted  one  by  one.  In  other  words,  the  cash,  com- 
prising one-half  of  all  postings,  the  expense,  com- 
prising one-fourth  of  all  postings,  the  freight,  com- 
prising one-eighth  of  all  postings,  are  made  in  totals, 
or  three  postings  in  all,  and  therefore  the  individual 
postings  need  be  but  the  remaining  one-eight  of  the 
total.  This  device  of  special  columns  in  the  cash 
book  is  of  almost  universal  use  in  businesses  having 
anything  more  than  a  small  number  of  transactions. 
The  number  of  such  columns  is  determined  solely  by 
convenience.  For  the  sake  of  showing  the  arrange- 
ment of  such  a  book,  an  illustration  is  given  on  page 
131  showing,  with  slight  changes,  the  entries  for  the 
transactions  given  in  the  common  cash  book  form  on 
page  123.  In  order  to  have  several  items  to  illustrate 
the  special  column,  various  accounts  kept  separate  in 
the  first  form  are  in  the  new  form  combined  in  Ex- 
pense. The  arrangement  of  the  debit  side  of  the  cash 
book  would  be  exactly  similar  except  that  the  special 
columns  would  be  for  the  use  of  different  accounts,  for 
the  accounts  which  bring  in  cash  are  usually  different 
from  those  which  cause  it  to  go  out. 


PEACTICAL  OPERATION' S  OF  BOOKKEEPING     131 


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132  ACCOUNTING  AND  AUDITING 

Blank  checks  are  used  in  the  ledger-folio  column  to 
indicate  that  the  work  of  posting  is  complete  and 
that  the  bookkeeper  has  looked  to  see  that  the  exten- 
sions for  special-column  items  are  in  the  proper 
columns. 

It  is  obvious  that  this  device  is  equally  service- 
able for  other  books  if  it  chances  that  the  transac- 
tions concerning  any  one  account  are  numerous 
enough  to  make  a  saving  of  labor.  For  instance,  if 
all  our  purchases  are  made  of  three  firms  it  would  be 
worth  while  to  arrange  our  purchase  book  so  as  to 
provide  one  column  for  each  of  these  firms.  Then 
any  purchase  from  any  one  of  the  three  would  be  ex- 
tended into  the  column  kept  specially  for  that  firm, 
the  total  of  the  column  would  be  posted  at  the  end  of 
the  month  to  the  credit  of  that  firm,  and  the  total 
of  all  columns  would  be  posted  at  the  end  of  the 
month  to  the  debit  of  Merchandise.  In  such  a  case, 
then,  four  postings,  one  to  Merchandise  and  one  to 
each  of  the  three  firms  of  whom  we  buy,  would  be 
all  that  would  be  necessary  for  all  the  transactions 
of  any  month.  Let  us  next  suppose,  to  take  an  ex- 
treme case,  that  we  buy  from  only  three  firms  and 
that  we  make  all  our  sales  to  four  firms.  It  would 
then  be  possible  with  seven  columns  to  get  upon  the 
ledger  all  merchandise  transactions  for  the  month 
with  only  nine  postings — one  to  Merchandise  debits, 
one  to  Merchandise  credits,  four  to  customers,  and 
three  to  creditors — and  this  would  be  true  however 
many  purchases  and  sales  were  made. 

Let  us  now  carry  this  principle  one  step  further. 
So  far  our  discussion  of  the  special  column  has  been 
concerned  with  entries  which  are  divided  into  two 


PKACTICAL  OPEEATIONS  OF  BOOKKEEPING     133 

equal  halves,  that  is,  those  in  which  one  debit  equals 
one  credit.  One  or  both  of  these  may  be  posted  in 
a  lump  sum  with  other  items.  The  use  of  the  special 
column  is  possible  also  when  one  or  both  sides  of  the 
entry  are  cut  up  into  several  parts.  Suppose,  for 
instance,  that  in  the  case  just  assumed  we  are  not 
selling  merchandise  on  our  own  behalf  but  as  agents 
for  others.  Let  us  assume,  for  the  sake  of  simplicity, 
that  we  guarantee  the  payment  for  all  sales  made. 
In  that  case,  whether  we  collect  from  our  customers 
or  not,  we  are  responsible  to  the  people  for  whom  we 
sell.  Finally,  we  assume  that  we  never  order  goods 
until  we  have  received  orders  for  them,  and  so  each 
purchase  corresponds  in  every  particular  (except 
commissions)  with  a  sale.  We  debit  our  customers 
at  the  maximum  price  and  credit  our  creditors  at  that 
price  less  our  commission.  By  providing  a  special 
column  for  commission  and  combining  our  purchase 
book  with  our  sales  book,  we  can  in  one  entry  debit 
the  customer,  credit  the  shipper,  and  credit  Commis- 
sion— all  without  repetition  of  a  figure  or  a  word  and 
with  only  eight  postings  for  any  number  of  transac- 
tions, four  for  customers,  three  for  creditors,  and  one 
for  Commission.  Such  a  combined  book  might  look 
as  follows: 


134 


ACCOUNTING  AND  AUDITING 


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PKACTICAL  OPEEATIONS  OF  BOOKKEEPmG     135 

Similarly,  we  may  have  in  our  journal  special  col- 
umns for  those  accounts  coming  most  frequently  in 
that  book.  When,  for  instance,  we  receive  from  our 
customers  notes  in  payment  of  their  bills,  and  when 
we  give  notes  in  payment  of  our  own  bills,  the  only 
book  on  which  the  entry  can  be  made  simply  is  the 
journal;  for  as  neither  cash  nor  merchandise  is  in- 
volved in  the  transaction  the  entry  cannot  go.  directly 
upon  the  cash  book,  the  purchase  book,  or  the  sales 
book.  If,  therefore,  we  provide  in  our  journal  a 
special  column  each  for  Bills  Receivable  debits  and 
for  Bills  Payable  credits,  we  may  avoid  the  necessity 
of  posting  journal  debits  to  either  of  those  accounts 
until  the  end  of  the  month;  then  the  total  of  the  col- 
umn for  each  kind  of  notes — debits  to  Bills  Receiv- 
able and  credits  to  Bills  Payable — can  be  posted  each 
as  one  lump  sum. 

Here  is  the  obvious  and  common  use  of  the  special 
coliunn.  Its  practicability  in  varying  circumstances 
can  readily  be  seen.  The  only  limitations  upon  its 
use  are  two:  first,  if  items  are  not  of  frequent  occur- 
rence in  any  book  for  any  account,  the  handling  of  a 
special  column  may  make  more  work  than  it  saves — 
for  it  always  involves  some  extra  writing  in  the  book 
of  original  entry;  second,  if  we  provide  a  large  num- 
ber of  special  columns  for  accounts  not  of  great  fre- 
quency our  books  become  so  bulky  that  time  is  lost 
in  passing  over  dead  columns  and  in  picking  out  the 
exact  column  into  which  each  entry  should  go.  Illus- 
trations are  given  below  of  a  form  of  journal  with 
special  columns  for  Bills  Receivable  and  Bills  Pay- 
able. These  assume  settlement  of  items  shown  on 
page  134  to  be  made  by  notes.    In  addition  will  be 


136  ACCOUNTING  AND  AUDITING 

found  another  form  used  a  number  of  years  ago, 
which  is  an  excellent  illustration  of  some  of  the  pos- 
sibilities of  the  special  column.  This  is  called  the 
columnar  journal.  It  is  a  sort  of  combination  cash 
book,  purchase  book,  sales  book,  and  journal.  The 
Cash  debit  column  is  the  same  as  the  debit  side  of  the 
common  cash  book.  The  Cash  credit  column  is  the 
same  as  the  credit  side  of  that  book.  The  Merchan- 
dise debit  column  is  the  same  as  the  purchase  book, 
and  the  Merchandise  credit  column  is  the  same  as  the 
sales  book.  This  form  of  journal  is  useful  for  a  small 
business  having  but  few  transactions.  The  illustra- 
tions here  are  based  on  the  transactions  shown  on 
page  134,  but  assume  that  goods  are  purchased  out- 
right and  that  payment  is  made  in  cash  for  both  pur- 
chases and  sales. 


PRACTICAL  OPERATIONS  OF  BOOKKEEPING     137 


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CHAPTER  VI 

DRAWING  CONCLUSIONS  FROM  THE  BOOKS 

Since  the  purpose  of  all  accounting  is  to  present 
the  ultimate  truth  regarding  values  and  profit  and 
loss,  the  most  important  thing  of  all  is  that  the  rec- 
ord shall  be  summarized  in  a  form  bringing  out 
clearly  the  desired  figures.  The  preparatory  step 
is,  if  possible,  to  prove  the  correctness  of  the  record. 
We  have  seen  all  along  that  debits  must  equal  cred- 
its, for  whenever  we  have  debited  any  account  as  re- 
sponsible we  have  credited  some  other  account  as 
conferring  the  responsibility.  Since,  then,  we  have 
all  along  provided  that  debits  shall  equal  credits  in 
our  original  entries,  it  must  be  true  that,  if  oiu*  post- 
ing is  correct,  the  total  debits  of  our  ledger  must 
equal  the  total  credits  of  our  ledger.  The  device  to 
test  correctness  is  simple.  It  usually  takes  the  form 
of  what  is  called  a  ''trial  balance."  In  its  simplest 
type  the  trial  balance  is  a  sheet  containing  the  names 
of  all  ledger  accounts  and  in  debit  and  credit  col- 
umns opposite  each  name  an  extension  of  the  amount 
of  the  debit  and  credit  total  of  that  account.  Then 
the  sum  of  all  the  debits  of  all  accounts  should 
equal  the  sum  of  all  the  credits.  To  make  such  a 
trial  balance,  however,  is  a  little  more  than  is  neces- 
sary. It  is  obvious  that  all  accounts  which  have 
been  closed,  so  that  they  now  show  no  excess  of  one 

138 


140  ACCOUNTING  AND  AUDITING 

side  over  the  other,  are  by  that  fact  akeady  proved 
to  have  debits  equal  to  credits;  and  since  our  only 
purpose  in  the  trial  balance  is  to  test  the  equality 
of  debits  and  credits,  we  have  no  need  of  these  ac- 
counts on  the  trial  balance.  Similarly,  if  we  wish, 
we  may  omit  all  but  balances  on  the  accounts  still 
standing  open;  for  as  the  balance  is  nothing  but  the 
excess  of  one  side  over  the  other,  in  omitting  all  ex- 
cept the  balance  we  are  simply  omitting  items 
already  proved  to  be  equal.  An  adequate  form  of 
trial  balance,  therefore,  is  the  trial  balance  of  ledger 
balances.  This  is  valuable,  too,  as  a  summary  of 
the  business  at  the  date  of  the  trial  balance.  It 
should  be  preserved  for  reference.  Below  will  be 
found  two  trial  balances  for  the  ledger  shown  on 
pages  126-128.  The  first  is  the  trial  balance  of  ledger 
totals,  and  the  second  is  that  for  ledger  balances.  In 
both,  the  numbers  at  the  left  of  the  names  indicate, 
for  reference,  the  numbers  of  the  ledger  pages  on 
which  the  accounts  are  found. 

One  inexperienced  in  bookkeeping  is  surprised  to 
learn  how  frequently  a  trial  balance  fails  at  first  to 
show  the  desired  equality  of  debits  and  credits. 
Errors  in  posting  are  much  harder  to  avoid  than  the 
novice  is  likely  to  think.  It  is  easy,  for  instance,  to 
post  an  item  to  the  wrong  side  of  an  account.  A 
bookkeeper  engaged  in  posting  is  shifting  contin- 
ually from  one  side  to  the  other  of  his  ledger,  and 
unless  he  watches  himself  very  carefully  or  is  think- 
ing constantly  of  the  meaning  of  every  posting  he 
makes — which,  as  a  matter  of  fact,  he  finds  difficult 
because  of  the  monotony  of  the  routine  labor  of  post- 
ing,— he  is  in  danger  of  losing  all  adequate  sense 


DEAWING  CONCLUSIONS  FROM  BOOKS      141 
[TRIAL  BALANCE,  JANUARY  31.— TOTAL  DEBITS  AND  CREDITS] 


Laurence   Sterne 

Cash 

Bills  Receivable 

Bills   Payable 

Real  Estate 

Interest 

Rent 

Merchandise 

Expense 

Furniture  &  Fixtures 

Postage 

Stationery 

Freight 

Delivery   Equipment 

Advertising 

Wages 

Insurance 

Fuel 

Profit  &  Loss 

Charles  Dickens 

Anthony   Trollope 

Alexander  Pope 

Walter  Scott 

Jonathan  Swift 

Richard  Steele 


225100 
31092i2o 

esoojoo 

400000 

1530000 

3260 


2600000 

2500 

60000 

1500 

12500 

6500 

50000 

3000 

8000 

10000 

10000 

10000 

400000 

70000 

600000 

700000 

107500 

70000 


10406485 


34993|75 

2819760 

470000 

1300000 


2350 

10000 

357500 


500000 

70000 

600000 

700000 

67500 

20000 


10406485 


[TRIAL  BALANCE,  JANUARY  31.— BALANCES] 


Laurence  Sterne 

Cash 

Bills  Reeceivable 

Bills   Payable 

Real  Estate 

Interest 

Rent 

Merchandise 

Expense 

Furniture   &   Fixtui 

Postage 

Stationery 

Freight 

Delivery   Equipment 

Advertising 

Wages 

Insurance 

Fuel 

Profit  &  Loss 

Charles  Dickens 

Jonathan  Swift 

Richard  Steele 


289465 
160000 

1530000 
910 

2242500 

25 
500100 

1500 
12500 

6500 
60000 

3000 

8000 
10000 
10000 
10000 

50000 
SOQlOO 


34768 


900000 
10000 


100000 


75 


4486875   44868175 


142  ACCOUNTING  AND  AUDITING 

of  what  he  is  doing,  and  is  likely  to  post  to  the  credit 
side  an  item  which  ought  to  go  to  the  debit. 

The  detection  of  this  sort  of  error  through  the 
trial  balance  is  sometimes  easy.  If  the  bookkeeper 
has  posted  to  the  wrong  side  he  has  produced  an 
error  in  the  ledger  of  double  the  amount  posted;  for, 
by  posting  to  the  wrong  side,  he  has  not  only  made 
one  side  larger  than  it  ought  to  be,  but  he  has  neces- 
sarily made  the  other  side  smaller  than  it  ought  to 
be;  and  whenever  we  at  the  same  time  make  one  side 
larger  and  the  other  smaller,  we  are  establishing  be- 
tween the  two  a  difference  twice  as  great  as  the 
amount  of  error.  This  may  be  illustrated  by  very 
simple  figures.  Suppose  we  have  to  post  2+3+4  to 
one  side,  and  6+2+1  to  the  other.  These  should  give 
equality,  or  9  on  each  side  of  the  trial  balance.  Sup- 
pose, however,  in  making  the  last  posting — which 
would  be,  we  will  say,  adding  1  to  the  credit  side, — 
we  make  the  error  of  adding  it  to  the  debit  side. 
Then  our  debit  side  reads  2+3+4+1,  and  our 
equation  reads,  since  our  1  is  now  omitted  from  the 
credit  side  by  the  error,  2+3+4+1=6+2;  which  is 
a  false  equation  by  twice  the  sum  of  the  original 
error,  or  10=8.  When,  therefore,  a  bookkeeper  finds 
in  getting  the  total  of  his  trial  balance  that  one  side 
is  larger  than  the  other  by  a  sum  divisible  by  twQ, 
he  recognizes  a  possibility  that  the  error  arises  from 
a  mistake  in  posting — or,  what  is  quite  as  likely,  a 
mistake  in  drawing  off  figures  from  his  ledger  to  the 
trial  balance — so  that  some  amount  is  placed  on  the 
wrong  side.  If  the  amount  of  discrepancy  divided 
by  two  is  a  peculiar  figiu'e,  such,  for  instance,  as 
$463.29,  it  is  a  matter  of  but  a  moment  usually  to  see 


DRAWING  CONCLUSIONS  FROM  BOOKS  143 

whether  that  sum  is  among  the  figures  involved  in 
the  month's  transactions  either  in  the  trial  balance 
itself  or  among  the  original  entries.  If  that  figure 
appears,  the  posting  should  be  examined  to  see  that 
it  has  not  got  upon  the  wrong  side. 

It  is  extremely  easy  for  a  bookkeeper  to  make  a 
slight  error  in  addition.  This  will  usually  a:ffect 
only  one  or  two  digits  in  a  number,  and  therefore  if 
his  trial  balance  fails  of  proof  Hj  sl  discrepancy  of 
one  or  two  figures— for  instance,  one  side  of  the  bal- 
ance reading  $164,213.20  and  the  other  side  $164,- 
313.20, — he  has  three  possibilities  worth  noting:  first, 
the  error  may  be  $50  on  the  wrong  side  in  the  original 
entry — for  the  discrepancy  is  $100,  and  $50  is  one- 
half  of  it;  or  it  may  be  in  transferring  from  the  ledger 
to  the  trial  balance  an  item  of  $50,  so  that  it  has  got 
upon  the  wrong  side ;  or  he  may  have  made  an  error  of 
1  in  adding  his  totals  on  the  ledger,  in  striking  a  bal- 
ance from  his  ledger  totals,  or  in  adding  the  trial 
balance  itself.  In  the  attempt  to  find  the  error  he 
will  naturally  look  first  at  the  places  where  it  would 
be  most  quickly  discovered  if  it  existed  there;  and, 
therefore,  he  will  first  examine  the  footings  of  his 
trial  balance,  then  the  transfers  from  the  ledger  to 
the  trial  balance,  next,  the  figuring  of  ledger  bal- 
ances themselves,  and,  finally,  the  additions  of  ledger 
figures.  If  the  error  is  still  undiscovered  he  will 
naturally  turn  next  to  the  additions  of  sums  posted 
to  the  ledger  in  total;  that  is,  the  additions  of  his 
purchase  book  or  sales  book  or  cash  book.  Obviously, 
if  in  adding  the  figures  of  his  sales  book  he  has  made 
an  error  of  $100,  the  amount  posted  as  a  debit  to  cus- 
tomers will  be  correct  because  composed  of  the  indi- 


144  ACCOUNTING  AND  AUDITING 

vidual  items,  but  the  posting  credited  to  Merchandise, 
being  derived  from  a  false  addition  of  the  sums  prop- 
erly debited  to  customers,  will  be  incorrect  by  the 
amount  of  the  error  in  addition. 

A  very  common  error  in  posting  is  due  to  the  fact 
that  we  can  all  remember  figures  better  than  we  can 
remember  the  order  of  those  figures.  Most  of  us 
have  had  the  experience  at  one  time  or  another  of 
writing,  for  illustration,  623  when  we  meant  632.  A 
bookkeeper  who  is  engaged  for  hours  consecutively 
in  making  postings,  especially  of  large  figures,  is 
likely  to  make  a  number  of  transpositions  of  this 
sort  unless  he  watches  himself  with  extreme  care. 
It  is  an  interesting  fact  that  any  transposition  of  fig- 
ures will  produce  a  discrepancy  divisible  by  9.  The 
difference  between  34  and  43,  for  instance,  is  9;  be- 
tween 27  and  72  is  45,  which  is  divisible  by  9;  and 
so  on  with  any  number  of  digits  in  any  possible  re- 
arrangement. It  is  sometimes  worth  while,  there- 
fore, for  a  bookkeeper  to  make  the  test  of  dividing 
his  discrepancy  by  9  to  see  whether  possibly  some 
figure  has  been  transposed.  If  he  finds  the  prob- 
ability here  he  may  be  helped  to  find  the  error,  but 
usually  not, — ^though  the  probability  may  Suggest  to 
him  where  he  had  best  look  to  see  the  mistake.  In 
case  the  discrepancy  is  divisible  by  9,  a  relation  can 
be  found  between  the  amount  of  discrepancy  and  the 
figures  transposed;  for  instance,  if  the  discrepancy 
is  9,  division  by  9  gives  1,  and  this  1  indicates  that 
the  difference  between  the  figures  transposed  is  1, — 
that  is,  23  for  32  or  vice  versa,  or  34  for  43,  or  45  for 
54,  or  56  for  65,  or  67  for  76;  and  the  difference  be- 
tween 461  and  164  is  297,  which  divided  by  9  gives  33, 


DEAWING  CONCLUSIONS  FROM  BOOKS  145 

indicating  by  its  repetition  of  3  (not  necessary  to 
explain  here)  that  the  middle  figure  is  not  changed, 
and  by  the  3  that  the  difference  of  transposed  digits 
is  3  (4 — 1) ;  and  the  difference  between  461  and  146 
is  315,  which  divided  by  9  gives  35,  indicating  that 
the  difference  between  the  first  two  figures  is  ^3  and 
between  the  last  two  figures  is  5.  This  is  of  very  little 
avail  to  a  bookkeeper  with  thousands  of  figures  be- 
fore him,  however,  except  as  a  hint  to  watch  for  the 
transposition  of  figures  with  the  difference  indicated. 
We  know  that  unless  there  has  been  some  mistake 
in  adding  figures  to  be  posted,  or  in  posting,  or  in 
striking  balances  on  the  ledger,  or  in  transferring  fig- 
ures to  the  trial  balance,  or  in  adding  the  trial  bal- 
ance, the  trial  balance  debits  must  equal  the  trial  bal- 
ance credits,  and  it  is  worth  while  to  find  wherein  lies 
any  discrepancy.  We  must  not  think  because  the  dis- 
crepancy is  only  a  few  cents  that  the  error  is  trivial; 
for  obviously  a  dozen  errors,  some  on  one  side 
and  some  on  the  other,  would  produce  a  bal- 
ance of  error  of  merely  the  difference  between 
the  debit  errors  and  the  credit  errors.  In  other 
words,  the  size  of  the  discrepancy  on  the  trial 
balance  gives  no  indication  whatever  of  the  num- 
ber or  size  of  the  errors  in  the  books.  For  in- 
stance, an  error  of  $5,000  omitted  from  the  debit  side, 
another  of  $10,000  omitted  from  the  credit  side,  an- 
other of  $15,000  omitted  from  the  debit  side,  and 
$9,999.99  omitted  from  the  credit  side,  would  give 
a  balance  of  error  of  just  one  cent;  for  the  total  debit 
errors  are  $20,000  and  the  total  credit  errors  $19,- 
999.99.  It  is  never  safe,  therefore,  to  proceed  with 
the  books  if  the  slightest  error  is  disclosed  in  the  trial 

A.  &  A-10 


146  ACCOUNTING  AND  AUDITING 

balance ;  for  the  discrepancy  indicates  unknown  error 
or  errors  of  unknown  amount  in  the  books  of  original 
entry  or  somewhere  between  the  original  entries  and 
the  trial  balance  footings. 

One  class  of  error  may  persist  in  the  books  in  spite 
of  a  trial  balance  which  proves  an  equality  of  debits 
and  credits.  If,  for  instance,  we  have  by  a  careless 
posting  credited  Robinson  when  we  meant  to  credit 
Brown,  we  have  done  nothing  which  affects  the  trial 
balance.  The  trial  balance  does  not  indicate  that 
every  figure  has  been  carried  to  the  proper  account, 
but  only  that  every  figure  has  been  carried  to  the 
correct  side  of  some  account.  No  one  must  rest  in  the 
false  assumption  that  his  books  are  correct  because 
he  has  a  good  trial  balance.  The  trial  balance  does 
establish  a  strong  presumption  that  the  books  are 
correct,  for  an  amount  is  much  more  likely  to  get 
upon  the  wrong  side  or  to  be  entered  with  an  error 
in  the  figures  than  wholly  in  the  wrong  part  of  the 
ledger.  Without  a  trial  balance,  on  the  other  hand, 
the  assumption  is  that  the  books  are  not  correct ;  for 
no  bookkeeper  can  work  without  occasional  error. 

In  one  other  case — very  improbable,  however — a 
trial  balance  may  show  equality  of  debits  and  credits 
and  yet  not  prove  the  correctness  of  the  books.  Just 
as  errors  may  occur  in  determining  balances  or  in 
transferring  to  the  trial  balance,  thus  throwing  out 
the  trial  balance  though  no  errors  exist  on  the  books 
themselves,  so  such  errors  might  happen  by  chance 
to  offset  errors  in  the  books;  and  thus  an  error  of 
$423.10,  for  instance,  in  the  books  might  chance  to 
be  exactly  offset  by  an  error  on  the  other  side  of 
$423.10  in  striking  balances  or  in  drawing  off  the 


DRAWING  CONCLUSIONS  FEOM  BOOKS    Ul 

trial  balance.  This  occurrence,  however,  is  very- 
much  against  the  law  of  chance.  The  chances  are 
several  thousand  to  one  against  it  in  even  a  small 
business,  and  perhaps  a  million  to  one  against  it  in 
a  large  business.  Should  such  a  thing  occur  it  could 
not  continue  long,  however;  for  it  is  against  all  reason 
that  it  should  occur  again  another  month,  and  a  trial 
balance  that  failed  to  show  equality  would  soon  dis- 
close the  error. 

Sometimes  a  month's  trial  balance  fails  ^^to 
come,"  that  is,  to  show  equality  of  debits  and  credits, 
after  a  test  of  all  the  sorts  known  to  bookkeepers. 
These  tests  are  intended  merely  to  suggest  probabil- 
ities iwith  regard  to  the  error.  When  they  fail,  the 
only  hope  lies  in  going  back  over  the  work  of  the 
month,  item  by  item.  The  desirable  thing  usually 
is  to  go  over,  item  by  item,  all  the  postings  of  the 
month,  rechecking  them  with  care  both  in  the  books 
of  original  entry  and  in  the  ledger.  This  checking  is 
usually  done  with  a  hard,  fine  pointed  pencil,  and  the 
check  marks  are  placed  in  the  double  ruling  where 
they  are  not  conspicuous.  Great  care  should  be  taken 
that  no  item  is  checked  either  in  the  book  of  original 
entry  or  in  the  ledger  until  its  counterpart  in  the 
other  has  been  found  to  be  upon  the  right  side  and  has 
been  found  to  be  of  the  right  amount.  To  check  it  in 
the  book  of  original  entry  before  its  counterpart  has 
been  found  is  to  run  the  risk  that  the  whole  purpose 
of  checking  will  fail.  When  all  the  work  has  been 
checked  up  in  this  fashion,  a  survey  of  the  books  of 
original  entry  and  of  the  ledger  should  show  at  once 
whether  any  item  has  been  entered  without  posting, 
and  whether  any  posting  has  been  made  without  a 


148  ACCOUNTING  AND  AUDITING 

corresponding  source  in  an  original  entry;  and,  of 
course,  if  any  entry  is  checked  twice,  or  if,  when  on 
the  point  of  checking  it,  one  finds  that  it  has  been 
already  checked,  something  is  wrong  at  that  point. 
If  this  checking  fails  to  disclose  the  error,  the  case 
is  discouraging.  Most  bookkeepers  would  at  this 
point  begin  all  over  at  the  very  start  as  if  they  had 
heretofore  made  no  effort  to  find  the  error. 

If  still  on  a  second  round  of  discovery  the  error 
is  not  found,  the  presumption  is  that  it  is  in  the  books 
of  the  preceding  month;  but  still  the  human  eye  and 
the  human  hand  are  so  fallible  that  it  is  usually  worth 
while  to  try  another  device  before  going  back.  This 
device  should  determine  whether  the  error  is  in  this 
month's  work.  Since  for  each  individual  entry  the 
debits  must  equal  the  credits,  the  total  debits  for  all 
the  accounts  for  any  month  must  equal  the  total 
credits  for  all  the  accounts  for  that  month;  and  if  we 
were  to  take  a  trial  balance  for  the  items  of  this 
month  alone,  regardless  of  any  items  on  the  ledger 
prior  to  the  beginning  of  this  month,  we  ought  to  find 
the  debits  equal  to  the  credits;  that  is,  if  in  a  trial  bal- 
ance including  only  this  month's  items  the  debits  do 
not  equal  the  credits,  and  there  is  no  mistake  in  draw- 
ing off  the  trial  balance,  the  error  is  in  the  books  for 
this  month.  This  fact  is  just  what  we  wish  to  learn. 
It  is  a  comparatively  simple  matter  to  take  a  trial 
balance  for  the  items  of  this  month.  When  the  ledger 
accounts  are  not  numerous,  this  may  usually  be  done 
by  simply  making  a  new  trial  balance  for  the  figures 
added  since  the  last  balance  was  taken;  but  if  the 
number  of  accounts  is  very  large,  so  that  it  is  difii- 
cult  to  see  from  the  ledger  just  what  items  belong  to 


DRAWING  CONCLUSIONS  FROM  BOOKS  149 

this  month,  it  will  be  simpler  to  make  new  postings, 
on  independent  sheets  of  paper,  for  the  items  of  this 
month  alone  and  then  take  a  trial  balance  of  those  in- 
dependent ledger  postings.  If  we  have  then  a  trial 
balance  which  proves,  it  is  obvious  that  the  error 
which  we  have  been  hunting  for  is  not  in  the  books  of 
original  entry  for  this  month.  It  is  either  in  this 
month's  ledger  figures,  or  it  is  of  earUer  date  than 
this  month's  transactions.  If  we  add  our  new  one- 
month  trial  balance  to  last  month's  trial  balance,  so 
as  to  produce  a  new  one,  a  comparison  with  the  faulty 
balance  will  show  in  what  accounts  there  is  discrep- 
ancy. Then  study  of  the  situation  will  show  just 
where  is  the  trouble. 

It  is  sometimes  thought  worth  while  to  learn  on 
which  side  of  the  ledger  an  error  disclosed  by  the  trial 
balance  is  to  be  found.  If  we  use,  in  our  trial  bal- 
ances, not  the  balances  of  open  accounts,  but  the  total 
amounts  of  debits  and  credits  for  each  open  and 
closed  account,  we  can  learn  by  subtracting  one 
month's  totals  from  the  preceding  month's  totals 
what  is  the  actual  total  of  all  ledger  debits  and  of  all 
ledger  credits  posted  for  that  month.  The  total  of 
the  purchase  book,  the  sales  book,  both  sides  of  the 
cash  book,  and  either  side  of  the  journal,  will  indi- 
cate the  total  amount  of  new  debits  which  ought  to 
have  been  made  to  all  accounts  during  the  month; 
that  is,  since  from  the  purchase  book  we  debit  Mer- 
chandise, from  the  sales  book  we  debit  customers, 
from  one  side  of  the  cash  book  we  debit  Cash  and 
from  the  other  side  debit  recipients  of  cash,  and  from 
the  journal  we  debit  all  other  items,  the  total  of  all 
these  must  be  the  total  debits  of  the  month.    Sim- 


150  ACCOUNTING  AND  AUDITING 

ilarly,  the  total  of  the  purchase  book,  the  sales  book, 
the  cash  book,  and  either  side  of  the  journal,  will  be 
the  total  necessary  credits  for  the  month;  for  we  have 
credited  our  creditors  from  the  purchase  book,  have 
credited  Merchandise  from  the  sales  book,  have  cred- 
ited Cash  from  the  disbursements  side  of  the  cash 
book  and  have  credited  sources  of  cash  from  the  re- 
ceipts side,  and  have  credited  miscellaneous  accounts 
from  the  credit  column  of  the  journal.  We  have  now 
a  complete  statement  of  what  this  month's  debit  post- 
ings and  credit  postings  ought  to  be,  and  what  the 
postings  for  each  side  actually  are;  so  one  can  readily 
see  which  side  of  the  trial  balance  is  in  error.  This 
may  reduce  the  labor  of  finding  the  particular  fault. 
Some  firms  keep  their  trial  balances  in  double  form, 
showing  both  totals  and  balances.  If  totals  are 
entered  in  black  and  balances  in  red,  confusion  is 
avoided. 

We  now  assume  that  our  books  have  been  prop- 
erly posted,  and  that  the  trial  balance  has  been  taken 
to  give  us  evidence  that  there^  is  no  error.  We  are 
concerned  next,  then,  to  draw  conclusions  from  the 
records  preserved  upon  the  books.  Eemembering 
that  we  have  three  kinds  of  accounts,  one  represent- 
ing property,  another  representing  persons,  and  a 
third  representing  known  forces,  we  may,  by  treating 
each  of  these  classes  of  accounts  as  its  nature  war- 
rants, determine  just  how  much  property  is  in  the 
business  and  how  great  are  our  profits  and  our  losses. 
As  we  saw  long  ago,  the  total  of  all  personal  accounts 
showing  a  debit  balance  represents  claims;  the  total 
of  all  property  accounts  showing  a  debit  balance  rep- 
resents property;  and  the  total  of  all  personal  ac- 


DEAWING  CONCLUSIONS  FROM  BOOKS  151 

counts  (excluding  that  of  the  proprietors)  'showing  a 
credit  balance  represents  debts.  So  the  sum  of  these 
debits  less  these  credits  represents  the  total  net  assets 
of  the  business.  The  account  of  the  proprietors, 
which  is  really  a  personal  account,  represents  their 
investment;  but  the  business,  though  accountable  to 
the  proprietors,  is  not  responsible  to  repay  them;  it 
needs  merely  to  show  what  it  has  done  with  the  value 
entrusted  to  it.  If  the  business  has  suffered  a  loss, 
the  net  assets  will  not  suffice  to  meet  the  liability  to 
the  proprietors,  and  if  it  has  earned  profit,  the  assets 
will  more  than  meet  that  liability.  The  net  invest- 
ment of  the  proprietors,  moreover,  is  shown  as  the 
credit  balance  of  their  personal  account.  The  total 
of  all  personal  accounts  having  a  credit  balance,  then, 
must  be  covered  by  all  the  assets,  or  the  business  has 
suffered  loss.  Any  excess  is  gain  for  the  period 
under  consideration;  for  since  the  proprietors  are 
credited  with  their  investment  as  it  stood  at  the  be- 
ginning of  the  year  (plus  any  investments  made  dur- 
ing the  year,  and  less  any  withdrawals  of  invest- 
ments), the  excess  of  total  assets  over  the  total  lia- 
bilities (including  the  proprietors'  investment) 
shows  the  amount  of  increase  of  assets,  or  net  gain, 
resulting  from  the  operations  of  the  business  for  the 
period.  Similarly,  a  deficiency  in  assets  shows  net 
loss  for  the  period. 

The  nominal  accounts,  on  the  other  hand,  since 
they  are  debited  for  losses  and  expenses  and  are  cred- 
ited for  earnings  or  gains,  also  must  show  this  same 
net  gain  or  net  loss  for  the  earning  period;  for  since 
we  have  never  debited  or  credited  one  of  these  nom- 
inal accounts  unless  we  were  at  the  same  time  cred- 


162  ACCOUNTING  AND  AUDITING 

iting  or  debiting  some  personal  account  or  property- 
account  (except  in  the  mere  case  of  a  transfer  from 
one  nominal  account  to  another,  which  does  not  affect 
the  total  of  them  all),  the  net  balance  of  all  nominal 
accounts  must  exactly  equal  the  net  balance  of  assets 
and  liabilities.  Any  excess  of  .assets  over  liabilities, 
we  have  seen,  indicates  an  increase  of  property,  and 
since  nominal  accounts  were  credited  whenever  there 
were  increases  in  property  to  explain,  the  net  credit 
to  such  nominal  accounts  must  equal  the  excess  of 
assets  over  liabilities.  Similarly,  if  the  liabilities,  in- 
cluding the  liability  to  the  proprietors,  are  in  excess 
of  the  assets,  it  is  because  the  business  has  lost  prop- 
erty through  shrinkage  or  expense  or  bad  debts;  and 
since  all  decreases  in  property  were  credited  to  the 
proper  accounts  and  at  the  same  time  debited  to 
nominal  accounts  by  way  of  explanation,  the  net  bal- 
ance of  debits  shown  by  the  combined  nominal  ac- 
counts must  exactly  equal  the  net  deficit  of  assets. 
So  our  method  of  double  entry  is  fulfilling  its  func- 
tion by  giving  us  at  the  end  of  the  period  an  explana- 
tion in  nominal  accounts  of  all  changes  in  property 
accounts. 

This  is  best  made  clear  in  drawing  conclusions  at 
the  end  of  an  earning  period  by  arranging  a  table  con- 
taining six  parallel  columns  to  show  the  debits,  the 
credits,  the  assets,  the  liabilities,  the  losses,  and  the 
gains.  If  each  kind  of  property  were  always  worth 
exactly  the  amount  of  net  debits  standing  to  its  ac- 
count on  the  ledger,  four  columns  would  do  as  well 
as  six,  for  all  debits  to  property  accounts  and  per- 
sonal accounts  would  be  resources,  all  credits  to  per- 
sonal accounts  would  be  liabilities,  all  debits  to  nom- 


DEAWING  CONCLUSIONS  FROM  BOOKS  1S3 

inal  accounts  would  be  losses,  and  all  credits  to  nom- 
inal accounts  would  be  gains;  but  as  a  matter  of  fact, 
as  we  have  seen  in  the  treatment  of  Merchandise, 
sometimes  our  debit  to  a  property  account  does  not 
represent  the  present  value  of  property  on  hand,  for 
there  are  likely  to  be  increases  and  shrinkages  in 
value  which  have  not  yet  been  entered  on  the  books. 
Our  Real  Estate,  for  example,  will  nominally  be  deb- 
ited for  the  value  of  real  estate  at  the  beginning  of 
the  year,  but  if  there  is  some  depreciation,  as  is  sure 
to  happen  with  regard  to  buildings  on  which  there 
have  not  been  large  repairs,  we  are  not  quite  repre- 
senting facts  as  they  are  if  we  leave  the  value  on  our 
books  at  the  end  of  the  year  as  it  was  brought  down 
at  the  beginning  of  the  year.  This  amount  of  depre- 
ciation is  clearly  a  loss,  and  we  should  indicate  it  not 
only  by  bringing  down  a  new  valuation  on  that  ac- 
count, but  also  by  entering  the  difference  or  shrink- 
age among  the  losses.  Since  the  basis  for  our  judg- 
ment of  values  and  of  profit  and  loss  is  the  trial  bal- 
ance, it  is  well  to  incorporate  the  trial  balance  in  this 
statement;  and,  therefore,  it  is  usually  convenient  to 
use  a  six-column  form,  as  shown  below.  The  figures 
used  for  illustration  are  taken  from  the  trial  balance 
on  page  141.  The  statement  is  immediately  followed 
by  a  detailed  explanation  of  its  construction  and 
meaning. 

We  have  here  but  one  month's  transactions,  but 
for  illustration  of  the  method  of  determining  profits 
they  will  do  as  well  as  would  figures  for  a  longer 
period.  We  will  proceed  to  extend  the  debit  and 
credit  trial  balance  columns  into  (1)  the  resource  and 
liability  columns  and  (2)  the  loss  and  gain  columns, 


164 


ACCOUNTING  AND  AUDITING 


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DKAWING  CONCLUSIONS  FEOM  BOOKS  155 

making  all  necessary  allowances  for  depreciation, 
losses  and  profits. 

It  must  be  recognized  in  the  first  place  that  every 
account  on  the  books  represents  property  or  claims 
on  the  one  hand,  or  profit  or  loss  on  the  other.  Every 
item  in  a  trial-balance  column,  then,  must  be  ex- 
tended  into  one  of  the  other  columns.  The  task  is  to 
choose  the  column.  If,  indeed,  any  allowances  are 
needed  because  the  books  have  not  brought  our  rec- 
ord quite  down  to  the  end  of  the  period,  some  of  these 
amounts  will  need  to  be  extended  into  two  columns. 
As  a  matter  of  fact,  it  is  impossible  for  the  books  in 
the  ordinary  course  of  affairs  to  represent  the  exact 
situation  of  all  accounts  day  by  day.  Many  things 
are  occurring  to  change  values  every  day  and  every 
hour,  and  to  keep  the  books  written  up  to  the  latest 
situation  would  require  altogether  too  much  labor. 
Interest,  for  instance,  is  accruing  every  day,  and  to 
keep  our  interest  account  always  up  to  the  moment 
would  mean  figiu'ing  upon  all  notes  and  bonds  daily. 
Wages,  again,  are  constantly  accruing,  and  whatever 
figure  we  should  have  on  our  books  at  ten  o'clock 
in  the  morning,  indicating  the  condition  of  the  wages 
element  of  cost,  would  need  to  be  altered  at  eleven 
o'clock.  Taxes  are  accruing  every  day;  the  same 
thing  is  true  of  insurance,  of  depreciation,  of  every- 
thing else  which  is  dependent  upon  the  lapse  of  time. 
Recognizing  the  absurdity  of  attempting  to  keep 
books  always  up  to  the  moment,  we  attempt  to  record 
facts  on  the  books  only  at  times  when  the  facts  reach 
some  culmination, — such  as  actually  becoming  due 
so  that  payment  can  be  demanded,  or  adjusted  to  a 
specific  date  because  at  that  date  it  is  desired  to  de- 


156  ACCOUNTING  AND  AUDITING 

termine  as  closely  as  possible  actual  profit,  loss,  and 
valuation.  We  must,  then,  at  any  time  when  we  de- 
sire to  ascertain  our  profits,  bring  our  books  down 
to  the  date  chosen  for  this  purpose.  This  will  neces- 
sitate many  allowances.  It  is  convenient  to  indicate 
these  allowances  first  on  the  six-column  statement, 
using  red  ink  in  the  resource  and  liability  col- 
umns to  show  that  the  amounts  are  different  from 
those  shown  on  the  books.  The  use  of  red  ink  is  not 
essential,  but  it  is  of  great  assistance  to  the  eye  be- 
cause it  calls  attention  to  the  fact  that  the  amount 
so  entered  is  taken  by  a  calculation  made  outside  the 
books  and  is  not  quite  in  accord  with  the  books  them- 
selves. When  the  six-column  statement  is  complete 
and  has  been  proved,  its  conclusions  may  be  entered 
on  the  books.  Let  us  work  out  the  process  in  detail. 
The  first  account,  that  of  the  proprietor,  Laurence 
Sterne,  may  be  at  once  extended  into  the  liability  col- 
umn, for  the  business  is  still  responsible  to  him  for 
his  investment.  It  is  obvious  that  when  we  have  fin- 
ished our  determination  of  profits  any  balance 
will  belong  to  him,  and  may  then  be  carried 
to  his  account;  but  for  the  present,  since  the  purpose 
of  this  sheet  is  to  learn  the  profits,  we  are  con- 
cerned only  with  the  present  credit  to  his  account  be- 
fore the  profits  of  the  year  have  been  determined. 
Cash  will,  of  course,  be  an  asset,  and  may  be  entered 
directly  in  the  resource  column.  Bills  Receivable  is 
also  an  asset.  Bills  Payable  is  a  liability,  and  should 
be  so  extended. 

Eeal  Estate,  representing  on  the  books  what  was 
supposed  to  be  the  value  of  the  property  at  the  be- 
ginning of  the  period  plus  any  additions  made  dur- 


DRAWING  CONCLUSIONS  FROM  BOOKS  157 

in^  the  period,  may  or  may  not  represent  exactly  the 
value  today.  There  has  been,  presumably,  some  de- 
preciation, even  though  in  the  course  of  one  month 
it  will  be  slight.  On  general  principles,  however,  we 
know  that  any  real  estate  is  constantly  running  down 
hill  unless  a  change  in  land  values  more  than  offsets 
a  change  in  buildings.  In  this  case,  to  be  on  the  safe 
side,  we  consider  the  property  to  have  depreciated 
to  the  amount  of  $25,  and,  therefore,  we  insert  in 
the  resource  column  in  red  ink  the  amount  of  $15,275. 
The  difference  between  $15,275,  which  we  conceive 
to  be  the  present  valuation,  and  the  original  $15,300, 
is  a  loss  of  $25,  and  this  is  entered  in  the  loss  column. 
Our  next  account.  Interest,  presents  more  compli- 
cation. We  have  debited  Interest  for  all  sums  which 
we  have  lost  because  of  the  force  which  interest  ac- 
count represents,  and  we  have  credited  Interest  with 
all  sums  accruing  to  us  from  that  source,  whether  col- 
lection has  actually  been  made  or  not.  When,  for 
instance,  we  took  at  the  beginning  of  the  year  certain 
notes  belonging  to  the  proprietor,  we  credited  him 
with  less  than  the  face  of  the  notes  because  we  must 
wait  for  the  money  until  some  time  in  the  future. 
Some  of  these  notes  do  not  mature  until  later  than 
the  end  of  the  month,  and  yet  our  credit  to  Interest 
was  made  as  if  the  profit  had  been  already  realized; 
the  first  note,  for  example,  was  dated  January  1,  and 
does  not  mature  until  March  1.  Yet  on  this  note  we 
credited  to  Interest  the  whole  difference  between  the 
face  value  and  the  amount  allowed  Sterne.  When  we 
are  concerned  to  learn  not  only  the  total  profits  for 
all  time  but  for  a  particular  period,  such,  for  example, 
as  those  for  the  month  of  January,  we  must  be  care- 


m  ACCOUNTING  AND  AUDITING 

ful  that  we  are  not  giving  credit  in  January  to  sums 
which  will  not  be  really  earned  until  later.  To  do  so 
may  misrepresent  very  seriously  the  profitableness 
of  one  period  as  compared  with  another.  To  do  jus- 
tice to  the  month  of  January,  we  must  now  see  how 
many  of  the  interest  items,  debited  and  credited  and 
still  to  be  debited  and  credited,  have  actually  been 
gained  or  lost  during  this  month.  This  can  be  readily 
learned  by  going  over  the  record  of  the  notes  now 
held  in  our  safe  and  of  those  outstanding  against  us. 
If  we  have  a  bill  book,  as  we  should  in  actual  business, 
we  can  at  a  glance  by  referring  to  that  book  see  which 
of  the  notes  are  now  outstanding;  for  as  soon  as  any 
is  paid,  either  to  us  or  by  us,  it  will  be  marked  ^'Paid'' 
in  that  book.  Having  no  such  book  before  us,  how- 
ever, we  may  now  turn  directly  to  the  ledger  accounts 
for  Bills  Eeceivable  and  Bills  Payable  and  see  what 
notes  have  not  been  canceled.  We  find  that  there  re- 
mains of  Bills  Eeceivable  one  note  for  a  thousand  dol- 
lars, which,  as  just  indicated,  has  one  month  to  run; 
the  interest  on  this  will  be  $5  at  six  per  cent.,  and, 
therefore,  since  we  credited  $10  to  Interest  at  the 
time  we  took  the  note,  $5  of  this  should  not  be  con- 
sidered as  yet  earned,  but  should  be  carried  over  to 
February.  This  $5  ought,  in  a  sense,  to  be  debited 
back  to  January  and  credited  to  February.  We  also 
hold  a  note  dated  January  16,  due  in  thirty  days, 
which  now  has  fifteen  days  to  run.  The  business  must 
wait,  therefore,  fifteen  days  before  it  can  realize 
upon  that  note,  and  since  the  month  of  February  does 
not  inherit  from  January  quite  so  much  as  the  books 
indicate — that  is,  it  inherits  a  note  for  $600,  but  must 
wait  fifteen  days  before  that  amount  can  be  collected 


DBAwm0  coisrcLusioisrs  from  books       159 

— ^this  discount,  of  $1.50,  should  also  be  deducted  from 
January  earnings  under  Interest.    These  two  items 
together  give  us  $6.50,  which  should  be  considered  as 
a  liability  of  January  toward  the  month  of  February. 
In  addition,  moreover,  we  issued  on  January  18  a 
note  for  $4,000,  bearing  interest;  the  interest  on  this 
has  already  accumulated  to  $9.33,  which  January  has 
thrust  upon  February  or  some  future  month  to  bear. 
This  interest,  therefore,  ought  to  be  charged  against 
January,  though  it  is  not  payable  for  some  time  to 
come.    The  sum  of  these  items,  $6.50  and  $9.33,  gives 
us  $15.83,  the  total  liability  of  January  to  the  future. 
We  have,  on  the  other  hand,  one  item  which  serves 
to  offset  this.     Turning  to  Bills  Payable,  we  find 
that  on  January  10  a  note  for  $5,000  was  issued,  not 
bearing  interest.    We  received  for  this  note  the  face 
value  less  interest,  $4,975.    Of  this  $25  charged  to 
Interest,  a  part,  $7.50,  was  really  chargeable  to  Feb- 
ruary because  the  note  does  not  become  due  until 
February  10.    We  must,  therefore,  allow  January 
this  $7.50,  for  of  this  loss  February  will  reap  the 
benefit  through  the  use  of  the  money.    This  amount 
deducted  from  our  $15.83,  previously  found  to  be  a 
liability  of  January,  leaves  January  a  net  liability 
to  the  future  of  $8.33.    This  we  now  enter  in  red  ink 
in  the  liability  column  of  our  six-column  statement. 
Interest  account  is  shown  by  our  trial  balance  to  have 
caused  a  loss  of  $9.10  already  charged  against  it,  and 
this  additional  net  liability  for  $8.33,  not  yet  on  the 
books,  gives  us  a  total  loss  on  account  of  interest  of 
$17.43,  which  we  enter  in  the  loss  column  of  our  state- 
ment. 

With  regard  to  Rent  we  have  a  somewhat  similar 


160  ACCOUNTING  AND  AUDITING 

situation.  The  trial  balance  shows  a  credit  to  Rent 
of  $100,  which  was  for  a  payment  three  months  in  ad- 
vance. Approximately  one-tenth  of  that  rent  has 
already  been  consumed  or  furnished  by  the  month  of 
January,  and,  consequently,  nine-tenths  remains  as 
a  liability  of  the  business;  that  is,  the  business  is  still 
responsible  to  supply  office  room,  or,  in  default  of  do- 
ing so,  to  return  the  money.  That  $90  is,  accordingly, 
a  liability,  and' the  profit  from  this  source  belonging 
to  the  month  of  January  is  only  the  difference  be- 
tween the  $90  and  the  $100,  or  $10.  So  we  enter  $90 
in  the  liability  column  in  red  ink  (to  show  that  the 
$90  does  not  appear  anywhere  upon  the  books)  and 
carry  $10  into  the  gain  column. 

We  have  already  worked  out  a  number  of  cases 
with  regard  to  Merchandise,  and,  therefore,  need  not 
dwell  upon  the  calculations  here.  We  have  only  to 
enter  in  our  resource  column  the  present  inventory 
of  Merchandise,  or  $23,376.10,  which  we  write  in  red 
ink  to  indicate  that  the  figure  is  not  taken  from  the 
books,  and  then  to  extend  the  difference  between  the 
trial  balance  debit  and  the  inventory  into  the  gain 
column  as  $951.10.  If  the  balance  of  Merchandise 
were  in  the  credit  column  of  the  trial  balance,  we 
should  know  that  the  sales  had  already  brought  in 
more,  by  that  amount,  than  the  cost  of  merchandise, 
and  to  find  the  profit  we  should  add  the  inventory 
to  that  credit  excess.  This  sum  would  be  carried  to 
the  gain  column. 

Our  expense,  we  find,  was  incurred  for  telephone 
service,  and  the  charge  was  for  three  months  in  ad- 
vance. Approximately  one-fourth  of  it  has  now  ex- 
pired, and  we  consequently  enter  in  the  resource  col- 


DRAWING  COiSTCLUSIONS  FROM  BOOKS  161 

umn  $18.75  in  reel  ink,  for  this  amount  is  still  an 
asset,  and  we  carry  $6.25  into  the  loss  column,  as  the 
amount  consumed.  Our  furniture  and  fixtures  are 
conceived  to  have  shrunk  in  value  $5,  and  conse- 
quently we  write  $495  in  the  resource  column  and  $5 
in  the  loss  column.  We  find  that  w^e  have  practically 
no  stamps  on  hand,  and  consequently  we  have  no  re- 
sources from  the  $15  expense  for  postage,  and  so 
we  extend  the  full  amount  into  the  loss  column.  Most 
of  the  other  items  are  shown  with  sufficient  clearness 
on  the  six-column  statement  itself  and  require  no 
comment  except  the  general  statement  that  wherever 
an  item  appears  in  red  ink  the  amount  is  conceived 
to  be  either  the  value  of  what  remains  of  the  prop- 
erty originally  charged  to  the  account  named,  a  claim 
accrued  but  not  yet  due,  or  a  liability  to  be  met,  and 
the  combination  of  that  sum  with  the  trial-balance 
figure  gives  the  loss  or  gain. 

The  accounts  of  Dickens,  Swift,  and  Steele  will 

be  extended  in  the  six-column  statement  exactlv  as 

«/ 

they  appear  upon  the  trial  balance,  for  no  allowance 
need  be  made  in  connection  with  them.  As  the  bus- 
iness owes  Dickens,  the  amount  will  be  extended  as 
a  liability;  and  as  Swift  and  Steele  owe  the  business, 
the  amounts  will  be  extended  as  resources. 

We  are  now  ready  to  put  our  conclusions  into 
more  summary  form.  It  is  evident  that  the  net  profit 
of  the  business  is  the  sum  of  the  column  of  gains  less 
the  sum  of  the  column  of  losses.  A  little  considera- 
tion will  remind  us  that  there  ought  to  be  also  another 
method  of  getting  the  same  profit  and  loss, — ^namely, 
from  the  relation  of  resources  and  liabilities.  Our 
resource  column  shows  what  we  now  have  on  hand, 

A  &  A-11 


162  ACCOUNTING  AND  AUDITING 

and  our  liability  column  shows  everything  for  which 
the  business  is  accountable,  both  to  outsiders  and  to 
the  proprietor.  The  difference  between  the  resources 
and  such  liabilities,  we  saw  long  ago,  is  profits.  If 
our  books  have  been  properly  kept,  since  whenever 
we  made  a  profit  or  suffered  a  loss  we  credited  or 
debited  some  profit  and  loss  account  as  well  as 
debited  or  credited  the  property  accoimt  concerned, 
the  difference  between  resources  and  liabilities  should 
exactly  equal  the  difference  between  losses  and  gains. 
We  find  when  we  take  totals  of  the  columns  of  our 
six-column  statement  that  the  resources  equal 
$45,458.25;  that  the  liabilities  equal  $44,867.08 ;  and 
the  difference  is  $591.17 — or  net  profit  as  shown  by 
the  increase  of  assets.  We  find,  on  the  other  hand, 
that  the  total  gains,  as  shown  by  the  gain  column,  are 
$961.10 ;  we  find  the  total  losses  to  be  $369.93 ;  and  the 
difference  is  $591.17.  In  other  words,  our  explana- 
tion or  nominal  accounts  have  shown  from  what 
sources  we  have  made  a  profit  of  $591.17,  and  our  real 
accounts  have  shown  property  distributed  through 
various  asset  accounts  to  have  been  increased  during 
the  year  by  the  same  amount,  or  $591.17.  Thus,  our 
six-column  statement  has  proved,  and  our  books  may 
be  assumed  to  be  correct  unless  we  have  made  some 
error  in  valuation  of  the  property  remaining.  This 
balance  of  $591.17  belongs,  of  course,  to  the  pro- 
prietor. 

It  is  to  be  remembered  that  the  figure  of  profit 
which  we  have  obtained  does  not  now  appear  upon 
the  books.  It  has  been  derived  to  great  extent  from 
figures  not  shown  upon  the  books,  such  as  the  valua- 
tion of  merchandise,  the  calculation  of  expired  in- 


DRAWING  CONCLUSIONS  FROM  BOOKS  163 

surance  premiums,  etc.  If  we  wish  our  books  to  show 
what  is  the  profit  at  this  time,  and  so  distinguish  this 
profit  from  future  profit,  we  must  bring  our  books 
into  accord  with  the  facts  by  entering  upon  them  the 
allowances  which  we  made  on  the  six-column  state- 
ment. This  may  be  done  by  either  of  two  methods. 
The  simple  way  is  to  enter  on  each  ledger  accoimt 
any  allowance  that  may  be  necessary  and  then  to 
transfer  to  Profit  and  Loss  on  the  ledger  the  balances 
of  all  accounts  showing  profit  or  loss.  The  second 
method  makes  use  of  journal  entries. 

In  illustration  of  the  first  method,  we  may  well 
take  ledger  accounts  showing  the  balances  found  in 
the  trial-balance  columns  of  our  six-column  state- 
ment on  page  154.  Beginning  with  Real  Estate,  which 
happens  to  come  first  on  oiu*  List,  we  should  insert 
in  red  ink  on  the  ledger,  just  as  we  have  done  on  the 
six-column  statement,  the  amount  of  $15,275  on  the 
credit  side.  A  credit  to  Real  Estate  indicates  that  the 
account  is  relieved  of  its  responsibility  by  that 
amount.  As  a  matter  of  fact,  if  we  close  the  books 
for  the  end  of  January  and  are  going  to  bring  down 
balances  for  the  month  of  February,  it  is  true  that 
the  real  estate  account  is,  so  far  as  January  is  con- 
cerned, relieved  of  responsibility  to  that  amount,  and, 
consequently,  there  is  warrant  for  making  this  entry. 
It  is  made  in  red  ink  to  indicate  that  the  item  con- 
sists of  a  mere  transfer  and  does  not  come  by  posting 
from  books  of  original  entry.  When  we  have  made 
this  entry  of  $15,275  on  the  credit  side,  the  account 
shows  a  balance  of  $25  for  the  debit  excess.  (See 
page  167.)  If  this  $25  is  not  now  remaining  in  the 
property,  as  is  here  the  case,  it  indicates  a  loss;  we 


164  ACCOUNTING  AND  AUDITING 

accordingly  enter  on  the  credit  side  in  red  ink  the 
item  ''Profit  and  Loss,  $25";  that  is,  we  have  bal- 
anced the  account  by  measuring  the  shortage,  by  the 
method  indicated  some  time  ago.  Here,  however, 
our  shortage  is  not  to  be  carried  down  to  the  new 
month,  as  usually  it  is,  but  to  be  carried  to  another 
account,  namely.  Profit  and  Loss.  We  accordingly 
turn  at  once  to  Profit  and  Loss  and  enter  on  the  debit 
side  the  item  ''Real  Estate,  L.  16,  $25."  (See  page 
169.)  This  is  entered  on  the  debit  side  because  it  is  a 
transfer,  to  this  account,  of  an  excess  debit  in  Real 
Estate;  for,  as  we  previously  indicated,  the  red  ink 
entry  on  the  credit  side  of  any  account  measures 
simply  the  excess  of  the  debit  side.  The  symbol 
"L.  16"  indicates  that  this  item  is  brought  to  Profit 
and  Loss  not  from  a  book  of  original  entry  but 
through  the  ledger,  page  16,  by  a  mere  transfer. 
Turning  back  now  to  Real  Estate,  we  see  that  the  in- 
ventory entry,  $15,275,  which  represents  the  property 
now  on  hand,  will  be  inherited  by  February,  and  this 
amount,  accordingly,  must  be  brought  down  as  a  new 
debit  balance  for  February  first.  To  summarize  this 
treatment  for  Real  Estate,  we  may  say  that  we  write 
two  items  on  the  credit  side  of  the  account  in  red  ink 
to  indicate  the  amount  of  debit  excess  of  that  account, 
and  of  these  two  items  one  represents  a  sum  carried 
down  to  February,  and,  therefore,  chargeable  to  Feb- 
ruary, and  the  other  represents  a  $25  loss  of  the  ex- 
cess of  the  January  debits  over  the  amount  trans- 
ferred to  February;  and  this  excess,  a  pure  loss,  is 
transferred  to  Profit  and  Loss. 

A  similar  method  of  transfer  would  be  followed 
for  all  the  accounts  concerned.    In  the  case  of  Inter- 


DEAWING  CONCLUSIONS  FROM  BOOKS  165 

est,  we  have  not  a  resource,  but  a  liability  to  be  met, 
and,  consequently,  a  red  ink  item  should  be  written 
on  the  debit  side  indicating  that  this  account  is  re- 
sponsible for  an  additional  sum  not  yet  recorded 
through  ordinary  channels.  (See  page  167.)  Then 
the  debit  side  is  $17.43  in  excess ;  and  that  balance  is 
transferred  by  writing  on  the  credit  side  *^  Profit  and 
Loss,  $17.43"  in  red  ink,  and  writing '' Interest,  L.  18, 
$17.43"  on  the  Profit  and  Loss  account  as  a  debit. 
What,  in  this  case,  must  be  brought  down  as  a  bal- 
ance to  February  1  Following  the  analogy  of  Real 
Estate,  we  should  bring  down  the  $8.33.  This  red  ink 
entry  as  a  liability  of  $8.33  represents  interest  for 
which  January  is  held  responsible,  though  this 
amount  will  not  reach  its  regular  entry  on  the  books 
until  some  time  in  February  or  later.  Let  us  ex- 
amine the  situation.  We  issued  in  January  a  note 
bearing  interest  for  which  payment  will  have  to  be 
made  in  February.  When  that  payment  is  made  in 
February,  Interest  will  be  debited,  but  as  that  interest 
belongs  properly  to  January,  February  should  not 
be  held  responsible  for  it.  If,  however,  we  bring 
down  from  the  month  of  January,  to  the  credit  side 
of  February,  the  $8.33  interest  liability  incurred  in 
January  but  not  yet  entered  on  the  books,  we  shall 
be  relieving  February  by  that  amount  from  the  re- 
sponsibility with  which  it  will  later  be  debited. 
Bringing  down  this  $8.33  from  the  red  ink  entry  on 
the  debit  side  of  January  to  the  credit  side  of  Feb- 
ruary will  forestall,  so  to  speak,  the  undue  debit  to 
February,  which  is  inevitable  at  the  time  the  interest 
is  paid.    This  will  leave  February  with  a  net  debit  on 


166  ACCOUNTING  AND  AUDITING 

account  of  this  payment  for  just  its  own  share  of  the 
interest  charged.    This,  of  course,  is  what  is  desired. 

The  same  thing  is  true  with  regard  to  Rent,  ex- 
cept that  here  we  have  a  gain,  instead  of  a  loss,  to 
transfer  to  Profit  and  Loss.  Eent  has  been  credited 
in  January  with  $100,  but  we  have  seen  that  only  $10 
of  that  really  belongs  to  January;  the  rest  was  col- 
lected for  February  and  later  months.  We  accord- 
ingly write  this  liability  of  $90  in  red  ink  on  the  debit 
side,  because  January  must  be  held  responsible  for 
collecting  $90  that  did  not  belong  to  it.  (See  page 
167.)  The  difference  between. these  two  sides  of  the 
account  ($100  originally  credited  and  $90  now  deb- 
ited) is  to  be  transferred  to  Profit  and  Loss.  We 
measure  that  difference  by  writing  '^Profit  and  Loss, 
$10''  in  red  ink  on  the  debit  side  of  Rent,  and  then 
we  transfer  it  by  writing  **Rent,  L.  22,  $10,"  on  the 
credit  side  of  Profit  and  Loss.  The  item  of  $90  on  the 
debit  side  of  Rent  must  now  be  brought  down  to  the 
February  account,  because  February  is  entitled  to 
credit  for  earning  rent,  even  though  the  payment  wa^ 
made  in  January.  February,  in  its  turn,  will  pass  on 
a  certain  unearned  portion  to  March  by  the  same 
process  as  that  by  which  January  passed  on  a  por- 
tion to  February. 

Practically  all  the  complications  which  can  arise 
in  this  connection  have  now  been  illustrated  in  the 
discussion  of  this  six-column  statement.  The  manner 
of  entry  is  indicated,  for  all  the  accounts  concerned 
in  our  six-column  statement,  on  pages  167-169.  Of 
course  the  final  balance  of  net  profit  or  loss  must  be 
carried  to  the  proprietor's  account.  His  account  is 
shown  with  the  others.    To  save  repetition  of  all  the 


DEAWING  CONCLUSIONS  FROM  BOOKS  167 

LAURENCE  STERNE  [Page  1 


BaUmce 


36359 

92 

■ 

i 

Jan. 
Feb. 

31 

1 

85359 

Balance 
Profit  &  Loss 


Balance 


L.  60 


34768 


35359 


35359 


CASH 


[Page  5 


Jan.  31  Balance 


2894  65 


BILLS  RECEIVABLE 


[Page  8 


Jan.  31  Balance 


1600  00 


BILLS  PAYABLE 


[Page  12 


Jan.  31  Balance 


9000  00 


REAL  ESTATE 


[Page  18 


Jan.  31  Balance 


Feb.  1  Balance 


15300 
15300 


15275 


Inventory 
Profit  &  Less 


L.  60 


15275 
25 


15300 


00 


INTEREST 


[Page  18 


Jan. 


Balance 
Accrued 


43 


Profit  <fc  Lo82 


Feb.   1  Balance 


L.  60 


17  43 


RENT 


[Page  22 


Unexpired  liability 
Front  d  Lost 


L.   60 


100 


Jan.  31  Balance 


Feb. 


Balance 


100  00 


100 


90 


MERCHANDISE 

[Page  25 

Jan. 

31 

1 

Balance 
Profit  <fc  Lo98 

Balance 

L.  60 

22425 
951 

00 
10 

10 
10 

Inventory 

23876 

10 

23876 

28376 

10 

Feb. 

23376 

EXPENSE 

[Page  30 

Jan. 

31 
1 

Balance 
Balance 

25 

00 

00 
75 

Uncomumed 
Profit  A  Lm% 

L.  60 

18 
6 

S 

25 

25 

00 

Feb. 

18 

- 

168 


ACCOUNTING  AND  AUDITING 

FURNITURE  A  FIXTURES 


POSTAGE 


[Page  35 


Jan, 

31 

1 

Balance 
Balance 

500 

00 

00 
0^ 

Inventory 
Profit  &  Loss 

L.   60 

495 
5 

00 
00 

500 

500 

00 

Feb. 

495 

[Page  39 


^an.  31  Balance 


Profit  <k  Loss 


L.60 

15 

15 

STATIONERY 

[Page  41 

Jan. 

81 
1 

Balance 
Balance 

125 

00 

00 
00 

Inventory 
Profit  &  Loss 

L.  60 

120 
5 

00 
00 

125 

125 

00 

Feb. 

120 

FREIGHT 


[Page  44 


Jan.  31  Balance 


Profit  &  Loss 


L.60 


65 


DELIVERY  EQUIPMENT 

[Page  48 

Jan. 

31 

1 

Balance 
Balance 

500 

00 

00 
00 

Inventory 
Profit  &  Loss 

L.60 

495 
5 

00 
00 

500 

500 

00 

Feb. 

495 

ADVERTISING 


Profit  &  Loss 


[Page  50 


Jan.   31  Balance 


30 


30\00 

30  00 


WAGES 


[Page  52 


Jan.    31  Balance 


Profit  &  Loss 


INSURANCE 

[Page  56 

Jan. 

31 
1 

Balance 
Balance 

100  00 

Unconswnert 
Profit  &  Loss 

L.  60 

98 

1 

75 
25 

100  00 
98  75 

100 

00 

Feb. 

FUEL 

[Page  58 

Jan. 

31 
1 

Balance 
Balance 

100 

00 

Inventory 
Profit  &  Loss 

L.  60 

^■5 
15 

00 
00 

100 

00 

100 

00 

Feb. 

85 

00 

DHAWmG  CONCLUSIONS  FROM  BOOKS 


169 


PROFIT  &  LOSS 

Balance 

100 

00 

I  al  Estate 

L.16 

25 

UU 

Interest 

L.18 

17 

43 

Expense 

L.30 

6 

2d 

F'rnit're  AFixt'res 

L.35 

5 

00 

Postage 

L.39 

15 

00 

Stationery 

L.41 

5 

00 

Freight 

L.  44 

65 

00 

Delivery  Eauipm't 

L.48 

5 

00 

Advertising 

L.50 

30 

00 

Wages 

L.52 

liO 

00 

Insurance 

L.56 

1 

25 

Fuel 

L.58 

15 

00 

Laurence  Sterne 

L.    1 

591 

17 

10 

961 

— 

[Page  60 


Jan. 


Rent 
Merchandise 


L.  22 
L.  25 


10  00 
95110 


961 


CHARLES  DICKEirS 


[Page  80 


Jan.  31  Balance 


1000  00 


JONATHAN  SWIFT 


[Page  84 


Jan.  31  Balan(.:^ 


SOOiOO 


RICHARD  STEELE 


[Page  85 


Jan.  31  Balance 


500  00 


items  of  the  ledger  shown  on  pages  126-128,  those 
items  are  consolidated  for  each  account  into  one  bal- 
ance, and  that  balance  is  given  below  as  if  the  ledger 
had  been  ruled  up  and  the  balances  brought  down  be- 
fore the  trial  balance  was  taken.  It  is  the  first  bal- 
ance of  each  account  below.  Then  follow  the  closing 
entries. 

One  objection  to  the  method  of  simple  transfer 
just  illustrated  lies  in  the  fact  that  nothing  in  the 
ledger  indicates  the  processes  by  which  the  amounts 
to  be  transferred  to  Profit  and  Loss  have  been  de- 
rived.    Some  careful  calculation  was  necessary  to 


170  ACCOUNTING  AND  AUDITING 

learn,  for  instance,  what  part  of  the  total  interest 
belongs  to  January  and  what  part  should  be  passed 
on  to  February.  This  method  of  transfer  leaves  no 
indication  of  the  details  of  that  computation.  It  is 
thought  by  many  bookkeepers  preferable,  therefore, 
to  make  all  transfers  through  the  journal.  In  order 
to  accomplish  this  they  make  journal  entries  which 
show  exactly  what  account  is  to  be  debited  and  what 
credited,  and  just  why  these  transfers  are  made. 
Below  will  be  found  the  journal  entries  for  the  trans- 
fers just  made  by  the  other  method.  When  these  are 
posted  the  results  are  identical  with  those  shown  on 
pages  167-169.  The  only  difference  will  be  in  the 
form  of  the  items  as  they  will  appear  upon  the  ledger. 
Since,  for  example,  all  items  come  from  the  journal, 
and  are  on  the  books  of  original  entry,  no  red  ink 
items  appear  except  as  mere  balances. 


[Entries  for  closing  the  books] 

31 

Profit  and  Loss                                                         35.00 

To  Sundries 

Eeal  Estate 

25.00 

Furniture  and  Fixtures 

5.00 

Delivery  Equipment 

5.00 

Depreciation  on  these  accounts  for  the  month 

(These  accounts  are  credited  not  because  what 
they  represent  has  done  anything  creditable,  but  be- 
cause they  are  now  relieved  of  their  responsibility 
by  the  transfer  of  that  responsibility  to  another  ac- 
count.) 


DEAWING  CONCLUSIONS  FROM  BOOKS  171 

81 

Profit  &  Loss  44.93 

To  Sundries 
Interest  17.43 

Expense  -  ^    6.25 

Stationery  5.00 

Insurance  ^     1.25 

Fuel  *   15.00 

Proportion  of  charges  expired    or  consumed 
during  the  month,  as  follows:     Expense    (tele- 
phone)  l^;  Stationery,  1/25;  Insurance,    1/80; 
Fuel,  15% ;  Interest,  as  follows : 
Accrued  on  B.  P.  No.  3,        9.33 
Unexpired  on  B.  R.  No.  1,    5.00 
Unexpired  on  B.  P.  No.  5,     1.50       15.83 


Less  unexpired  on  B.  P. 

No. 

2, 

7.50 

8.33 

Dr.  balance  on  ledger 

9.10 

Total 

17.43 

. 

31 

^ 

Profit  &  Loss 

To  Sundries 

Postage     * 

Freight 

' 

Advertising 

., 

Wages 

To  close  these  accounts 

190.00 


15.00 
65.00 
30.00 
80.00 


172 


ACCOUNTING  AND  AUDITING 


31 


Sundries 

* 

To  Profit  &  Loss 
Merchandise 

951.10 

Kent 

10.00 

To  transfer  gains  as  follows : 

Merchandise : 

Inventory- 

23376.10 

Net  debits,  per  ledger 

22425.00 

Gain 

951.10 

Eent: 

Collection 

100.00 

Unexpired 

90.00 

Income 

10.00 

961.10 


31 
Profit  &  Loss    . 

To  Laurence  Sterne 
To  transfer  the  balance  of  profit  to 
his  account 


591.17 


591.17 


The  process  of  figuring  profit  and  closing  the 
books,  as  worked  out  in  detail,  requires  a  consider- 
able amount  of  labor.  This  would  be  done  in  most 
business  houses  only  annually.  Here  we  took  a 
month's  interval  only  because  we  chanced  to  have  a 
month's  material  at  hand.  The  only  work  done  at 
monthly  intervals  is  in  most  houses  the  posting  of  the 
purchase  book,  the  sales  book,  and  the  cash  book,  and 
the  taking  of  the  trial  balance. 

When  the  books  have  been  closed  for  an  earning 
period,  by  closing  out  loss  and  gain  accounts,  a  new 
situation  is  shown  by  the  books.  If  we  were  at  this 
point  to  take  a  new  trial  balance  and  make  a  new  six- 
column  statement,  what  should  we  find'?    In  the  first 


DRAWING  CONCLUSIONS  FROM  BOOKS  173 

place,  there  are  no  proiit  and  loss  balances,  for  all 
profit  and  loss  have  been  carried  to  the  proprietor's 
account  —  and  that  represents  a  liability.  So  we 
should  have  no  use  for  the  loss  and  gain  columns  in 
the  six-column  statement.  The  resource  and  liability 
columns,  moreover,  would  be  a  mere  duplication  of 
the  trial-balance  columns;  for  every  debit  represents 
an  asset,  and  every  credit  a  liability.  A  six-column 
statement,  therefore,  would  contain  no  more  informa- 
tion than  would  a  trial  balance.  Usually  business 
men  report  their  business  operations,  so  far  as  they 
report  them  at  all,  only  after  the  closing  of  the  books; 
and  so  six-column  statements  are  not  published.  The 
results  of  the  six-column  statement,  however,  are 
usually  given  in  two  independent  statements.  One 
of  these  gives  the  equivalent  of  the  loss  and  gain  col- 
umns, and  is  called  the  *  income  account,"  or  ^^  income 
sheet."  We  shall  have  occasion  to  examine  the  form 
later.  The  other  is  the  ^^ balance  sheet,"  and  gives 
a  summary  of  the  ledger  as  it  stands  after  the  closing 
of  the  books.  In  form  it  usually  consists  of  two 
parallel  lists,  assets  and  liabilities,  instead  of  one  list 
in  parallel  columns  like  the  trigcl  balance;  but  in  sub- 
stance it  is  simply  the  trial  balance  in  new  form.  A 
developed  form  of  balance  sheet  will  be  discussed 
later.  Below  is  the  balance  sheet,  in  simple  form, 
for  the  ledger  shown  on  pages  167-169.  It  will  be 
noted  that  (except  for  the  proprietor's  account)  it 
corresponds,  item  for  item,  with  the  resource  and 
liability  columns  of  the  six-column  statement  on  page 
154.  The  exception  in  the  case  of  the  proprietor's 
account  is  due  to  the  fact  that  the  net  profits,  which 


174 


ACCOUNTING  AND  AUDITING 


in  the  other  statement  stood  in  the  last  two  columns, 
have  now  been  transferred. 


ASSETS 

, 

LIABILITIES 

Cash 

2894  65 

Laurence 

Sterne 

35361  92 

Bills  Beceivable 

1600  00 

Bills  Payable 

9000  00 

Keal  Estate 

15275  00 

Interest 

6  33 

Merchandise 

23376  10 

Eent 

90  00 

Expense 

18  75 

Charles  Dickens 

1000  00 

Furniture  &  Fixtures 

495  00 

stationery 

120  00 

/ 

Delivery  Equipment 

495  00 

Insurance 

98  75 

Fuel 

85  00 

Jonathan  Swift 

500  00 

Richard  Steele 

500  00 

45458  25 

45458  25 

CHAPTER  Vn 

SOME  HIGHLY  DEVELOPED  TYPES  OF 
BOOKKEEPING 

It  is  worth  while  now  to  examine  some  more 
highly  developed  types  of  bookkeeping,  for  no  one 
is  competent  to  interpret  books — as  an  auditor,  for 
example,  often  has  to  do — unless  he  can  read  them 
even  in  extremely  complicated  form.  Let  us  carry 
the  principle  of  the  special  column  further  than 
heretofore. 

We  have  heretofore  considered  the  trial  balance 
as  an  abstract  of  the  ledger.  When  we  realize  that  a 
large  business  may  have  transactions  with  a  great 
many  customers  (some  of  the  big  department  stores 
have  accounts  with  many  thousand  customers),  we 
see  that  a  trial  balance  may  be  extremely  volumi- 
nous and  may  involve  so  much  labor  that  the  figures 
are  not  available  for  several  days  after  work  is  begun 
upon  it.  It  is  desirable  to  have  on  the  balance  sheet 
and  on  the  trial  balance  one  figure  to  represent  aU 
customers.  This  may  be  provided  by  a  subordinate 
ledger  and  an  account  in  the  general  ledger  to  repre- 
sent that  subordinate  ledger.  If  we  put  all  cus- 
tomers' accounts  in  a  separate  ledger,  independent 
of  the  general  ledger,  we  shall  by  so  much  reduce  the 
bulk  of  our  general  ledger,  and  make  it  possible  for 
one  man  to  devote  all  his  attention  to  those  accounts 

175 


176  ACCOUNTING  AND  AUDITING 

without  interfering  with  other  bookkeepers.  Such  a 
book  would  be  called  the  ^^ sales  ledger,"  or  ^^cus- 
tomers ledger."  We  may  now  have  in  our  general 
ledger  an  account  to  represent  the  sales  ledger  as  a 
whole,  and,  so  far  as  our  general  ledger  is  concerned, 
consider  all  the  customers  as  one  customer.  If,  at 
the  end  of  the  month,  when  we  credit  Merchandise 
for  the  sales  as  shown  by  the  sales  book,  we  at  th'e 
same  time  debit  this  account,  which  we  may  call 
^'Customers,"  or  *' Accounts  Receivable,"  in  the  gen- 
eral ledger,  the  debit  to  Customers  in  the  general 
ledger  will  exactly  equal  the  total  debit  posted  to  all 
individual  customers  in  the  subordinate  sales  ledger: 
and  it  will  have  been  attained  with  only  one  posting. 
If,  similarly,  whenever  in  the  cash  book  we  credit  a 
customer  we  extend  the  amount  in  a  special  column, 
and  then  not  only  post  to  his  account  in  the  subordi- 
nate sales  ledger  but  at  the  end  of  the  month  post  the 
total  of  that  column  into  the  general  ledger  as  a 
credit  to  Customers,  the  balance  of  Customers  will 
always  represent  the  sums  due  us  by  customers,  and 
will  agree  with  the  total  amount  shown  in  the  sub- 
ordinate sales  ledger  as  due  by  all  customers.  Cus- 
tomers in  the  general  ledger,  in  other  words,  shows 
us,  without  our  looking  at  the  subordinate  ledger,  the 
total  balance  of  all  customers'  accounts:  it  is  an 
account  with  customers  as  a  bunch.  If,  however,  we 
wish  to  know  how  much  of  that  bunch  total  is  owed: 
by  any  individual,  we  must  turn  to  the  subordinate^ 
sales  ledger,  for  there  only  are  shown  the  details  of 
the  bunch.  Such  an  account  in  the  general  ledger 
serves  as  a  check  or  control  on  its  corresponding  sub- 
ordinate ledger,  and  is  for  that  reason  usually  called 


SOME  EIGSLY  DEVELOPED  TYPES  IW 

a  ^^controlling  account.''  The  business  may  be,  in- 
deed, of  such  magnitude  that  it  is  worth  while  to  have 
a  separate  customers'  ledger,  or  sales  ledger,  for 
each  initial  letter  of  customers'  names;  and  in  that 
case  it  might  be  worth  while  to  keep  in  the  general 
ledger  a  corresponding  controlling  account  for  each 
subordinate  customers'  ledger.  Under  that  plan, 
whenever  a  debit  is  made  to  a  customer  whose  name 
begins  with  A,  a  debit  must  also  be  provided  for  the 
account  called  ^^ Customers  A"  in  the  general  ledger; 
and  whenever  a  credit  is  made  to  such  a  customer,  a 
corresponding  credit  is  provided  for  Customers  A  in 
the  general  ledger.  Accounts  in  customers'  ledgers 
do  not  appear  on  the  trial  balance,  of  course,  for  they 
are  represented  there  by  the  corresponding  control- 
ling accounts;  but  at  convenient  times  the  total  bal- 
ance of  all  customers'  ledgers  should  be  compared 
with  the  controlling  accounts,  and  any  discrepancies 
explained  and  rectified. 

Controlling  accounts  are  of  use  in  many  other  con- 
nections. Often  a  separate  purchase  ledger  is  desira- 
ble. The  account  to  represent  it  in  the  general  ledger 
is  usually  called  ^* Accounts  Payable,"  or  '^ Cred- 
itors." In  some  lines  of  business,  for  instance,  it  is 
desirable  to  know  daily  the  net  balance  of  a  large 
group  of  accounts  which  it  would  be  almost  impossi- 
ble to  balance  and  add  daily.  By  keeping  a  control- 
ling account  in  the  general  ledger  to  represent  the 
total  of  all  the  detailed  accounts,  one  can  have  that 
balance  always  available.  In  a  savings  bank,  for 
illustration,  it  is  desirable  daily  to  know  the  sums 
due  to  depositors.  To  add  the  balances  of  all  the 
depositors'  accounts  is  a  very  heavy  task.    The  de- 

A  &  A-12 


178  ACCOUNTING  AND  AUDITING 

posits  account,  representing  in  tlie  general  ledger  the 
total  of  all  deposit  ledger  balances,  shows  the  desired 
figure  at  all  times. 

The  extra  work  in  keeping  controlling  accounts 
is  really  insignificant.  The  only  thing  required  is 
usually  that  a  separate  column  shall  be  kept  in  the 
cash  book  and  in  the  journal,  and  that  extension  shall 
be  made  to  this  column  whenever  a  change  occurs  in 
any  account  included  in  the  group  which  the  control- 
ling account  represents.  In  the  purchase  book  and 
the  sales  book  a  separate  column  is  hardly  necessary, 
for  the  total  of  all  purchases  and  of  all  sales  should 
usually  go  directly  to  Creditors  and  to  Customers. 

Let  us  now  apply  this  principle  of  the  special  col- 
umn for  a  controlling  account  to  a  case  which  will 
introduce  another  new  element.  We  saw  in  Chap- 
ter V.  that  discounts  may  be  taken  out  of  notes  and 
other  face  figures  (such  as  bills  to  be  paid)  by  entry 
on  the  contrary  side  of  the  cash  book — just  as  if  the 
full  sum  had  been  paid  and  then  a  rebate  given.  It 
is  obvious  that  when  discounts  are  frequent,  as  they 
are  with  firms  offering  and  taking  merchandise  dis- 
counts for  all  payments  made  to  them  or  by  them, 
it  is  a  good  deal  of  labor  to  write  the  discount  on  the 
opposite  side  for  each  discount  taken,  for  each  dis- 
count must  be  fully  explained.  It  would  be  a  vast 
convenience  if  the  discount  could  be  attached  di- 
rectly to  the  payment,  for  then  no  new  explanation 
would  be  necessary.  This  can  be  accomplished  if 
the  cash  book  has  a  special  column  for  discounts. 
With  such  a  column,  one  line  and  one  writing  of  the 
facts  will  do  for  both  amounts,  for  one  explanation 
covers  both  the  discount  entered  in  one  column  and 


SOME  HIGHLY  DEVELOPED  TYPES  179 

the  amount  of  the  bill  or  the  net  amount  entered  in 
another  column  on  the  same  line.  The  compUcation 
now  lies  in  the  fact  that  the  discount,  though  written 
on  one  side  of  the  cash  book,  really  belongs  on  the 
other — for,  as  we  have  seen,  since  it  is  an  amount 
subtracted  from  the  face  of  the  bill,  and  the  face  of 
the  bill  is  entered  as  if  received  in  full,  we  must  offset 
that  exaggeration  by  an  item  on  the  other  side.  We 
can  do  that  easily  at  the  balancing  of  the  cash  book 
for  that  period — the  week  or  the  month — ^by  trans- 
ferring the  total  of  the  special  discount  column  to  the 
other  side  of  the  cash  book,  just  as  we  transferred  the 
single  item  when  we  were  making  entries  one  by  one. 
The  custom  when  making  these  transfers  is  to  place 
in  the  explanation  column  the  word  ^^ contra,"  to  in- 
dicate that  the  amount  is  brought  from  the  opposite 
page.  This  is  illustrated  in  the  two  forms  below, 
which  have  each  a  column  also  for  the  controlling 
account. 

In  this  form  it  will  be  noted  that  a  balance  has 
been  brought  over  from  the  preceding  period  and 
stands  in  a  column  by  itself.  The  purpose  of  this 
column  is  to  make  it  possible  to  get  a  total  for  all 
receipts  during  the  present  period  without  complica- 
tion with  the  balance  brought  over  from  the  pre- 
ceding period.  If  this  sum  were  not  set  aside,  it 
might  be  included  in  the  total  to  be  debited  to  Cash; 
and  this  would  be  erroneous,  for  since  all  cash  re- 
ceipts of  the  previous  period  were  debited  during 
that  period,  any  unexpended  balance  brought  over 
from  that  period  must  not  now  be  debited  again. 
Several  devices  are  possible  to  keep  this  balance  out 
without  the  necessity  of  a  special  column.    One,  for 


180 


ACCOUNTING  AND  AtJDITlNd 


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SOME  HIGHLY  DEVELOPED  TYPES 


181 


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300 

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Invoice  No.  57 
''       No.  60 
Office  Supplies 
Paid  note  H.  S 
Invoice  No.  58 
''       No.  59 
Discount  contra 

Dombey  &  Son 
Henry  Esmond 
Expense 
Bills  Payable 
Adam  Bede 
Silas  Lapham 

Creditors 
Expense 

Discount — contra 
Cash,  Cr. 
Balance 

I>-t^^         G0O5'^rHi-(i-l           y^ 

rH  rH  T— 1  C^ 

1 

182  ACCOUNTING  AND  AUDITING 

instance,  is  adding  it  at  the  foot  of  the  page  after  the 
total  cash  receipts  have  been  figured.  This  is  unob- 
jectionable except  for  the  fact  that  until  this  balance 
has  been  inserted  the  books  do  not  show  what  is 
the  cash  required  to  be  on  hand,  and,  therefore,  they 
are  false  at  all  times  except  when  the  cash  book  is 
balanced.  Sometimes  the  balance  is  brought  over  as 
the  first  entry  in  the  Sundries  coliunn,  but  when  the 
cash  book  is  closed  and  posting  is  to  be  made  to  the 
Cash  account,  the  amount  posted  is  the  total  less  the 
balance.  The  amount  to  be  posted  is  indicated  by 
what  is  called  a  '* short  extension";  that  is,  the 
amount  is  not  written  in  the  extension  column.  This, 
again,  is  unobjectionable  except  for  the  fact  that  it 
does  not  look  right.  To  place  in  the  money  column 
a  figiu^e  which  is  obviously  a  correct  figure,  because 
it  is  the  amount  of  an  addition  of  the  figures  above  it, 
and  then  to  post  a  smaller  figure,  looks  decidedly 
suspicious. 

The  amoimt  extended  in  the  Customers'  and 
Creditors'  columns  is  the  full  face  of  each  bill  in 
spite  of  the  fact  that  less  than  the  full  face  was  paid; 
for  we  must  credit  the  customers  and  debit  the  cred- 
itors with  the  full  face  of  each  bill  because  in  each 
case  the  full  amount  is  entered  on  the  ledger,  and  we 
must  show  that  the  account  has  been  squared.  The 
amount  of  discount  is  the  subtraction  from  the  full 
face.  In  closing  the  cash  book,  the  total  discount 
found  by  adding  the  Discount  column  is  carried  to 
the  other  side  of  the  cash  book  and  entered  there  in 
the  Sundries  column  with  an  indication  that  it  comes 
from  the  other  side  of  the  book.  In  the  place  where 
it  originates,  the  word  *^ Discount"  is  not  written  in 


SOME  HIGHLY  DEVELOPED  TYPES  183 

the  journalization  column,  for  no  posting  is  made  of 
this  item  from  this  place.  The  journalization  column 
is  left  blank  and  only  the  explanation  is  used  in  con- 
nection with  the  amount.  It  wUl  be  noted  here  that 
$130.00,  which  is  the  total  of  the  Discount  column  on 
the  receipts  side  of  the  cash  book,  is  carried  over  to 
the  foot  of  the  disbursements  side  in  the  journaliza- 
tion and  Sundries  columns,  and  is  not  only  posted 
from  that  source  but  is  included  in  the  credit  to  Cash. 
This  is  as  it  should  be,  for  the  amount  of  discount  on 
the  receipts  side  is  the  same  as  an  equivalent  of  cash 
paid  out,  and,  therefore,  should  be  credited  to  Cash 
and  debited  to  Discount,  as  it  now  is,  on  the  disburse- 
ments side  of  the  cash  book.  Similarly,  the  footing 
of  the  Discount  column  on  the  disbursements  side  of 
the  book,  which  is  $89.00,  is  carried  to  the  receipts 
side  of  the  cash  book  and  there  entered  in  the  sun- 
dries column.  This  is  as  it  should  be,  for  those  dis- 
counts are  equivalent  to  receipts  because  they  were 
subtracted  from  bills  which  were  paid,  and  therefore 
are  to  be  debited  to  Cash  and  credited  to  Discount 
when  the  cash  book  is  posted. 

It  would  be  possible,  of  course,  instead  of  carry- 
ing the  amount  of  discount  appearing  on  each  side 
of  the  book  to  the  other  side  and  posting  it  thence, 
to  strike  a  balance  between  the  two  sides  and  post 
only  the  excess.  This  would  produce  the  right  effect 
on  the  cash  account,  but  it  would  hardly  give  the  full- 
est information  with  regard  to  discount.  One  indi- 
cation of  the  goodness  of  our  accounts  receivable  is 
the  number  of  discounts  which  our  customers  take, 
for  a  firm  on  the  verge  of  insolvency  is  not  likely  to 
be  able  to  pay  its  bills  promptly  and  receive  the  dis- 


184  ACCOUNTING  AND  AUDITING 

counts  for  prompt  payment.  If  we  were  to  combine 
our  Discount  debits  with  our  Discount  credits  and 
post  only  balances,  we  should  be  offsetting  all  dis- 
counts which  we  ourselves  received  against  discounts 
taken  by  our  customers,  and  we  should  have  no  indi- 
cation of  the  actual  magnitude  of  either  side  of  the 
account.  This  would  mean  that  in  comparing  one 
year  with  another  we  should  not  know  whether  we 
ourselves  had  taken  more  or  fewer  discounts,  and 
whether  our  customers  were  improving  or  not. 

The  double  ruling  under  the  total  of  the  two  Dis- 
count columns  indicates,  as  double  ruling  always  in- 
dicates, that  the  amount  goes  no  farther  in  this  con- 
nection. Here,  for  instance,  the  amount  is  not  car- 
ried into  the  Sundries  column,  but  stops  short.  This 
writing  of  it  is  to  be  neither  added  nor  subtracted. 
When  it  is  transferred,  the  new  writing  is  not  so 
double  ruled,  for  it  is  to  be  employed  in  connection 
with  other  figures. 

The  footing  of  the  column  for  Customers  is  post- 
ed to  Customers  in  the  general  ledger,  and  will  ex- 
actly equal,  of  course,  the  postings  made  to  the  sub- 
ordinate, or  customers'  ledger,  from  the  individual 
items.  This  amount  is  also  extended  into  the  Sun- 
dries column  because  it  must  be  included  in  the  Cash 
debits — for  the  excess  over  the  amount  actually 
received  is  offset  by  the  discount  transferred  to  the 
other  side  of  the  cash  book. 

This  matter  of  the  treatment  of  discounts  is  in- 
teresting because  it  shows  how  great  a  variety  of 
forms  and  processes  is  open  to  any  bookkeeper  in 
the  treatment  of  his  items.  It  should  be  remem- 
bered, as  has  already  been  suggested,  that  but  two 


SOME  HIGHLY  DEVELOPED  TYPES  186 

principles  govern  the  arrangement  of  books.  The 
first  is  the  need  that  everything  shall  be  very  clearly 
stated  and  so  arranged  that  it  can  be  easily  under- 
stood by  any  ordinary  reader  familiar  with  book- 
keeping. The  second  is  that  items  shall  be  so  ar- 
ranged that  posting  can  be  conveniently  made  to  the 
ledger,  which  is  the  ultimate  destination  of  all  fig- 
ures of  debit  and  credit.  If  it  is  found  in  any  case 
that  one  arrangement  is  better  adapted  to  the  needs 
of  this  business  or  to  the  temperament  of  the  book- 
keeper than  another,  that  arrangement  is  to  be  pre- 
ferred. In  the  form  just  illustrated  it  is  seen  that 
the  full  amount  of  the  bill  is  written  in  the  column 
for  the  controlling  account,  and  that  the  discount  is 
written  in  a  column  by  itself;  so  that  the  actual 
amount  of  Cash  is  the  difference  between  the  two; 
but  by  extending  the  total  amount  of  discount  to  the 
other  page  at  the  end  of  the  week  or  the  month  the 
proper  balance  of  Cash  is  preserved.  If,  however, 
we  wish  to  see  what  cash  was  actually  collected  on 
any  bill,  we  must  perform  a  subtraction  of  the 
amount  in  the  Discount  column  from  the  amount  in 
the  other  column.  It  is  obvious,  however,  that  it 
would  be  possible  so  to  arrange  the  books  that  the 
discount  would  not  need  to  be  carried  to  the  other 
page.  If,  for  instance,  instead  of  entering  opposite 
the  name  of  the  customer  the  full  amount  of  the  bill, 
we  should  enter  the  net  amount  paid  by  him  after 
the  discount  was  deducted,  the  total  of  the  column 
would  be  the  total  cash  received  and  would  be  the 
proper  debit  to  Cash  without  regard  to  discount.  It 
is  equally  obvious,  however,  that  in  posting  to  the 
customer's  credit  we  should  need  to  use  not  merely 


186  ACCOUNTING  AND  AUDITING 

the  net  amount  of  the  bill — that  is,  the  face  less  the 
discount, — but  the  full  amount,  or  the  sum  of  the  two 
items  written  in  the  cash  book — that  is,  the  amoimt 
which  he  pays  plus  the  discount  allowed;  for  on  the 
ledger  he  is  debited  with  the  full  amount  of  the  bill 
and  our  credit  to  him  must  be  of  sufficient  amount 
to  show  that  his  bill  has  been  paid.  This  introduces 
a  slight  complexity  from  the  fact  that  in  posting  it 
is  usually  awkward  to  add  two  sums  together  in  the 
head  and  accurately  transfer  that  amount  to  the 
ledger.  Some  bookkeepers,  however,  like  this 
method.  It  is  shown,  for  the  receipts  side  of  the  cash 
book,  with  the  items  used  in  the  previous  form. 

This  form  has  one  new  peculiarity.  The  amount 
of  discount  on  the  receipts  side  of  the  cash  book  must 
be  posted  as  a  debit,  for  it  represents  a  deduction 
from  our  collections :  that  is.  Discount  is  responsible 
for  our  failure  to  collect  the  face  of  the  bills.  Yet 
normally  items  on  the  debit  side  of  the  cash  book  are 
credits, — for  since  the  debit  side  of  the  cash  book 
shows  items  to  be  debited  to  Cash,  it  shows  items  to 
be  credited  to  other  accounts.  This  discount,  however, 
has  no  real  relation  to  Cash,  and  is  on  the  cash  book 
only  for  convenience.  The  credit  to  the  customer  is 
from  two  items — one  of  cash  and  one  of  discount.  To 
put  them  together,  with  one  explanation,  saves  writ- 
ing. This  discount  column,  then,  is  really  only  a  jour- 
nal entry  inserted  in  the  cash  book  for  economy  of 
labor.  Care  must  be  taken  that  it  is  plainly  labeled 
to  be  debited,  for  otherwise  its  position  here  might 
lead  to  erroneous  crediting  of  it. 

Our  treatment  of  totals  here  is  necessarily  differ- 
ent from  that  in  the  last  form.    Since  discoimt  is 


SOME  HIGHLY  DEVELOPED  TYPES 


187 


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188  ACCOUNTING  AND  AUDITING 

directly  subtracted,  and  not,  as  before,  added  to  the 
other  side  of  the  cash  book,  our  posting  to  Customers 
at  the  end  of  the  period  must  be  the  sum  of  the  net 
cash  column  and  the  Discount  column — for  the  credit 
to  each  customer  as  the  bills  were  paid  was  necessa- 
rily the  sum  of  those  two  items  for  each  bill;  our 
total  net  cash  must  be  included  in  the  sundries  col- 
umn, to  be  debited  to  Cash;  and  our  total  discount 
may  be  debited  directly  from  this  place.  We  may 
provide  for  all  this  by  a  simple  precaution  in  the 
order  of  taking  totals.  If  we  first  take  the  total  of 
net  cash,  we  may  extend  the  item  into  the  Sundries 
column  and  thus  provide  for  our  Cash  debit.  Since 
we  must  include  the  Discount  in  the  credit  to  cus- 
tomers, we  next  take  the  footing  of  the  Discount  col- 
umn, which  must  be  independently  posted,  and  then 
extend  it  into  the  net  cash  column  after  the  total  of 
net  cash  has  been  determined.  By  adding  the  Dis- 
count to  the  net  cash  we  get  the  full  amount  to  be 
posted  as  a  credit  to  Customers. 

Another  device  to  serve  the  same  end  is  to  enter 
the  full  amount  of  the  bill  in  the  Customers  column, 
to  enter  the  discount  in  the  Discount  column,  and  to 
carry  the  net  amount  to  the  Sundries  column.  Then 
all  figures  are  provided :  we  post  to  the  credit  of 
the  customer  the  amount  in  the  total  column,  we 
credit  to  Customers  the  total  of  the  total  column,  we 
include  the  net  amount  in  the  Cash  receipts,  and  we 
post  to  Discount,  as  a  debit,  the  total  of  the  Discount 
column — which,  as  in  the  last  form,  has  really  noth- 
ing to  do  with  Cash.  This  is  complete  and  simple. 
It  is  shown  below: 


SOME  HIGHLY  DIVBLOPED  TYPES 


189 


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a                             Account  Feb. 
le                             Note  A.  Scot 

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190  ACCOUNTING  AND  AUDITING 

In  this  form  both  the  column  for  Customers  and 
that  for  Discount  are  really  for  journal  entries  alone, 
and  have  no  effect  upon  the  amount  of  Cash.    We 
have  extended  into  the  Sundries  column  the  net 
cash  in  every  case,  and,  therefore,  that  amount  is 
automatically  included  in  the  receipts.     The  Cus- 
tomers column,  containing  the  total  of  all  bills,  must 
be  posted  as  a  credit  to  Customers,  and  the  total  of 
Discount  must  be  posted  as  a  debit  to  Discount,  for 
it  is  this  discount  and  the  cash  which  together  make 
up  the  equivalent  credit  to  Customers.     The  only 
peculiarity  of  the  arrangement  here  is  a  provision 
that  neither  the  amount  of  total  for  Customers  nor 
that  of  Discount  shall  get  into  the  Cash  columns. 
This  form  has  for  its  advantage  over  the  others  that 
it  shows  at  all  times  the  actual  totals  of  all  accounts 
concerned.    It  is  impossible  under  the  first  form  to 
find  the  cash  receipts  without  first  finding  the  Dis- 
count total,  subtracting  it  from  the  Customers,  and 
adding  the  remainder  to  the  sundry  cash  receipts.   It 
is  impossible  under  the  second  form  to  learn  the 
credit  to  Customers  without  adding  the  Discount  to 
the  net  cash,  and  it  is  impossible  to  learn  the  total 
cash  receipts  without  adding  the  net  cash  to  the 
sundry  cash.    Here,  however,  the  total  of  the  Sun- 
dries column  is  always  the  total  cash  receipts,  and 
the  total  of  Customers  is  the  total  credit  to  Cus- 
tomers. 

All  this  sounds  very  complicated,  but  in  practice 
as  soon  as  one  has  learned  the  lay  of  the  land  it  works 
very  simply. 

We  have  just  seen  forms  in  which  certain  items 
that  really  belong  on  the  journal  are  introduced  into 


SOME  HIGHLY  DEVELOPED  TYPES  Idl 

the  cash  book  because  they  may  be  inserted  there  in 
special  columns  with  perfect  clearness  and  without 
explanation.  This  suggests  the  fact  that  the  cash 
book  may  be  used  commonly  as  a  journal  for  any 
items  if  only  the  items  are  written  on  both  sides.  It 
is  common  in  banking,  for  instance,  to  enter  many 
things  not  cash  at  all  on  both  sides,  and  to  designate 
on  the  debit  side  of  the  cash  book  the  name  of  the 
account  to  be  credited  and  on  the  credit  side  of  the 
book  the  name  of  the  account  to  be  debited.  When 
these  items  are  posted  in  the  ordinary  course,  the  cor- 
rect results  are  attained;  for  the  cash  balance  is  not 
affected,  and  items  on  the  debit  side  of  the  cash  book 
are  of  course  credited  and  those  on  the  other  side 
are  debited.  Let  us  now,  in  order  to  see  this  prin- 
ciple in  its  fullness,  apply  it  to  an  extremely  compli- 
cated form.  One  who  thoroughly  understands  this, 
and  can  reproduce  it  and  make  desired  changes  in  it 
without  throwing  it  out  of  order,  may  be  said  to  have 
mastered  the  principle  of  the  special  column. 

Let  us  assume  a  commission  business  in  which  we 
receive  commissions  on  sales  which  we  make  and 
pay  commissions  on  sales  made  for  us.  We  also  buy 
certain  merchandise  directly  for  our  own  account 
and  sell  it  both  directly  and  on  commission.  Our 
profits  are  both  commission  and  gain  on  merchandise, 
and  our  losses  are  both  commission  and  losses  on 
merchandise.  We  have  then  a  variety  of  purchasing 
and  selling  relations.  It  is  desired  in  such  a  business 
to  keep  constant  run  of  the  course  of  profits,  and, 
therefore,  to  figure  profit  and  loss  on  each  shipment 
for  sale  on  commission.  In  the  illustration  given 
below  it  will  be  seen  that  we  save  entries  by  treating 


in  \CCOltNTtNG  AND  ATTBITIKG 

as  cash  things  that  are  not  cash,  for  by  entering  such 
items  in  connection  with  other  items  repetition  of 
explanation  is  saved,  and,  though  the  amount  of  cash 
is  overstated,  the  balance  is  correct.  This  form  also, 
it  will  be  noted,  provides  special  columns  for  several 
controlling  accounts.  We  have,  then,  a  combination 
of  practically  all  the  complexities  of  bookkeeping 
form. 

In  this  business,  four  separate  subordinate  ledg- 
ers are  kept:  a  consignment  ledger,  with  a  separate 
account  for  each  lot  of  goods  received  to  be  sold  on 
consignment — that  is  to  say,  to  be  sold  for  others  on 
a  commission  basis;  a  shipment  ledger  with  an  ac- 
count for  each  lot  of  goods  shipped  to  others  from 
our  own  stock  to  be  sold  by  them  for  us  on  commis- 
sion; a  customers  ledger  for  customers;  and  a  cred- 
itors ledger  for  creditors.  It  is  necessary  to  keep  in 
the  general  ledger  an  account  to  represent  each  of 
these  subordinate  ledgers.  We  must  debit  each  con- 
signment with  expenses  and  commission  and  remit- 
tances to  the  shippers,  and  we  must  credit  each  with 
what  we  get  for  the  goods.  We  must  debit  each  ship- 
ment with  what  the  goods  cost  us  and  expenses  and 
commission  allowed  to  our  agents,  and  credit  each 
with  the  net  receipts  from  our  agents.  To  close  ship- 
ments accounts,  moreover,  we  must  debit  them  for 
gains — to  make  the  debits  equal  the  receipts, — and 
credit  them  for  losses — to  make  the  credits  equal  the 
debits.  It  is  convenient,  moreover,  to  close  such 
shipment  accounts  as  soon  as  possible,  for  the  man- 
agers must  govern  their  future  shipments  by  the 
results  of  present  and  past  shipments.  If  cer- 
tain goods  shipped  to  a  certain  town  always  result 


SOME  HIGHLY  DEVELOPED  TYPES  193 

in  a  loss,  a  manager  ought  to  know  it  as  soon  as  pos- 
sible. It  will  save  labor,  moreover,  if  we  can  close 
each  such  shipment  account  at  the  time  of  receiving 
the  final  ^^ account  sales" — that  is,  the  final  report, 
from  the  agent,  concerning  that  shipment;  for  then 
the  loss  or  gain  may  be  placed  in  a  special  column, 
without  explanation,  in  connection  v/ith  the  entry  of 
the  amount  received  from  the  shipment. 

In  om*  cash  book,  therefore,  we  must  provide  a 
large  number  of  special  columns,  for  we  have  not 
only  expenses  and  discounts  and  profit  and  loss,  but 
several  controlling  accounts.  On  the  receipts  side, 
our  controlling  accounts  will  be  Shipments  —  for 
amounts  received  from  shipments  sent  away, — Con- 
signments— for  amounts  received  for  goods  sold  for 
others, — and  Customers.  On  the  disbursements  side 
our  controlling  accounts  will  be  Shipments — for  ex- 
penses, commission,  etc., — Consignments — for  ex- 
penses and  remittances  sent  to  shippers, — and  Cred- 
itors. For  most  of  these  controlling  accounts,  more- 
over, there  will  be  more  than  one  column,  for  in  many 
cases  the  payments  are  likely  to  be  less  than  the  full 
amount  of  the  bill.  When  payment  is  received  for 
goods  which  have  been  shipped  away  to  be  sold  on 
commission,  the  amount  may  be  more  or  less  than 
the  sum  debited  to  that  shipment  account,  for  com- 
mission is  always  to  come  out,  loss  may  have  been 
suffered,  or  profit  may  need  to  be  added.  Similarly, 
when  payment  is  made  to  those  for  whom  the  busi- 
ness has  sold  goods  on  consignment,  less  is  paid 
than  the  full  price  received  on  the  goods,  for  commis- 
sion is  to  be  deducted.  When,  again,  payment  is 
made  for  merchandise  purchased,  discount  is  likely 

A.  &  A-13 


194  ACCOUNTING  AND  AUDITING 

to  be  deducted.  Obviously,  the  commission,  the  dis- 
count, the  loss,  and  the  gain,  are  not  properly  cash 
items  and  do  not  belong  ux3bn  the  cash  book;  but  if 
we  can  save  labor  by  inserting  in  that  book  items 
that  do  not  theoretically  belong  there  it  is  worth 
while  to  do  so.  Many  forms  will  serve  this  purpose. 
We  will  take,  for  practice,  not  the  simplest  but  the 
most  complicated.  The  reader  wishing  to  improve 
his  understanding  of  the  principle  of  the  special  col- 
umn is  recommended  to* see  clearly  the  full  meaning 
of  this  and  then  to  devise  ways  of  simplifying  it,  as 
suggested  later. 

The  first  column  on  the  debit  side  of  the  cash 
book  indicates  the  total  amount  received  on  settle- 
ment with  those  who  sell  shipments  for  us.  Obvi- 
ously, it  this  amount  is  more  for  any  shipment  than 
that  shipment  cost  us  as  shown  by  the  shipment 
ledger,  the  difference  is  gain.  It  may  be  entered  at 
once  in  the  gain  column.  If  the  return  is  less  than 
the  cost,  the  loss  nmy  be  entered.  Our  shipments 
account,  not  only  in  the  general  ledger  but  as  a  total 
of  the  items  in  the  shipments  ledger,  must  balance  so 
far  as  each  particular  shipment  is  concerned;  and  to 
make  it  balance  the  gain  or  loss  must  be  entered. 
Shipments,  in  other  words,^must  be  credited  for  more 
or  less  than  the  actual  receipts  by  the  amount  of  loss 
or  gain;  but  gains  may  as  well  be  added  to  the  debits 
as  subtracted  from  the  credits ;  so  losses  are  credited 
to  Shipments  and  gains  are  debited. 

These  items  of  gain  and  loss  are  really  not  cash 
items  at  all,  for  their  only  connection  with  cash  is 
registered  in  the  amount  entered  in  the  Shipments 
column — which  shows  the  amount  of  cash  actually 


SOME  HIGHLY  DEVELOPED  TYPES 


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ash  sales.  S.  B. 
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196  ACCOUNTIKG  AND  AUDITING 

received.  Entries  for  them  need  simply  to  close  each 
shipment  account  and  transfer  the  gain  or  loss  to  a 
nominal  account — ^just  as  in  the  last  chapter  we  made 
journal  entries  to  close  various  accounts.  These  en- 
tries could  perfectly  well  go  upon  the  journal,  as  has 
already  been  indicated;  but  for  every  entry  of  this 
sort  an  explanation  would  need  to  be  'made,  and  that 
would  involve  rewriting  the  history  of  the  trans- 
action. If  the  entries  are  made  here,  however,  no 
additional  explanation  is  necessary.  Our  present 
bookkeeping  problem  is  then  to  provide  means  of 
debiting  Shipments  and  crediting  Gain,  and  of  debit- 
ing Loss  and  crediting  Shipments,  for  the  amounts 
shown  in  the  Gain  and  Loss  columns.  We  have  seen 
that  any  item  may  be  placed  on  the  cash  book,  even 
though  no  cash  is  involved,  if  only  it  is  put  on  both 
sides.  If,  then,  we  carry  the  total  of  the  Gain  col- 
umn, $6.25,  into  our  Sundries  column,  as  if  it  were  a 
cash  receipt,  and  write  the  word  '^Gain"  in  the  jour- 
nalization column,  this  amount  will  be  posted  as  a 
credit  to  Gain  at  the  closing  period.  If,  at  the  same 
time,  we  carry  this  $6.25  also  to  the  other  side  of  the 
cash  book  and  there  call  it  ^^ Shipments,"  it  will  be 
posted  in  due  course  as  a  debit  to  Shipments  (be- 
cause items  appearing  on  the  credit  side  of  the  cash 
book  are  debited  to  the  accounts  named)  and  we  shall 
have  produced  just  the  desired  effect.  The  debit  and 
the  credit  to  Cash,  though  both  excessive,  offset  each 
other.  Similarly,  if  we  extend  the  $5.10,  which  is  the 
total  of  the  Loss  column,  into  the  Sundries  column  as 
a  cash  receipt,  and  call  it  '^Shipments,"  to  Shipments 
it  will  be  credited  when  the  book  is  posted,  as  we  have 
already  seen  that  it  ought  to  be.    If,  finally,  we  carry 


SOME  HIGHLY  DEVELOPED  TYPES  197 

this  $5.10  also  to  the  disbursements  side  of  the  cash 
book  and  there  call  it  ^^Loss,"  it  will  be  posted  as  a 
debit  to  Loss,  as  we  have  already  seen  it  ought  to  be. 
We  have,  then,  by  carrying  both  of  these  totals  to 
both  sides  of  the  cash  book,  but  in  one  case  calling 
them  ^^ Shipments"  and  in  the  other  calling  them  by 
their  natural  names,  produced  the  same  effect  as  if 
we  had  made  a  journal  entry,  or,  rather,  two  journal 
entries,  to  express  the  situation.  Since,  in  the  form 
as  shown,  the  $6.25  gain  on  the  credit  side  of  the 
cash  book  should  be  posted  as  a  debit  to  Shipments, 
it  may  be  extended  into  the  Shipments  column  and 
so  be  posted  in  total  with  the  other  Shipments  items. 
Otherwise  it  must  needs  have  a  separate  posting. 
Similarly,  the  loss  appearing  on  the  debit  side  is  to 
be  credited  to  Shipments,  and  so  we  save  a  posting 
by  inserting  it  in  the  Shipments  column  so  that  it 
shall  be  included  with  the  other  credits  to  Shipments 
and  be  posted  in  a  lump  sum.  The  other  half  of  each 
of  these  entries,  however,  is  posted  individually,  and 
is  individually  extended  into  the  Sundries  column; 
for  there  are  no  other  Gain  items  on  the  debit  side  of 
the  cash  book  and  no  other  Loss  items  on  the  credit 
side. 

The  next  column,  *^ Consignments,"  includes  cash 
receipts  from  the  sale  (not  charged  to  any  customer) 
of  goods  sent  to  us  on  consignment,  and,  therefore, 
shows  the  amount  which  should  be  credited  not  only 
to  Consignments  but  to  the  individual  consignment 
accounts  in  the  consignment  ledger — for  since  these 
goods  belong  to  shippers,  we  must  be  sure  that  in 
each  case  we  credit  the  shipper  with  the  receipts  on 
bis  own  goods.    Since  it  shows  an  actual  receipt  of 


198  ACCOUNTING  AND  AUDITING 

cash,  the  amount  is  finally,  of  course,  extended  into 
the  Sundries  column.  The  next  column,  that  for  Cus- 
tomers, again  represents  a  receipt;  but  since  the 
amount  to  be  credited  to  Customers  is  the  full  face 
of  all  bills  paid,  regardless  of  discount,  any  over- 
statement of  Cash  when  the  amount  is  extended  into 
the  Sundries  column  must  be  offset  by  the  items  in  the 
next  column  which  are  carried  to  the  opposite  side  of 
the  cash  book  whenever  the  book  is  balanced.  The 
Merchandise  column  contains  cash  receipts  from  the 
sales  (not  charged  to  any  customer)  of  merchandise 
directly  from  our  own  stock  without  the  intervention 
of  any  commission  merchant,  and  is  finally,  of  coiu'se, 
extended  into  the  Sundries  column. 

When  we  come  to  close  the  cash  book  we  must 
note  that  on  the  receipts  side  the  total  Discount  col- 
umn is  not  to  be  extended  into  the  Sundries  column 
nor  to  be  posted  from  this  source,  but  is  to  be  carried 
to  the  other  side  of  the  book;  that  the  amount  of 
Loss  is  not  to  be  extended  into  the  Sundries  column, 
for  it  is  included  among  the  Shipments;  and  that 
before  ruling  up  the  page  we  must  bring  over  from 
the  opposite  side  the  amount  of  Discount  found  there 
as  a  deduction  from  the  bills  which  we  have  paid. 

On  the  disbursements  side  of  the  cash  book  we 
find  a  similar  condition.  Shipments  is  here  debited 
for  expenses  incurred  in  sending  goods  away  for  sale 
on  commission,  and,  as  we  have  already  seen,  for  the 
amount  of  gain  as  shown  by  the  other  side  of  the  cash 
book.  Consignments,  on  the  other  hand,  represents 
the  remittances  or  expenses  incurred  for  goods  which 
we  have  sold  for  others;  and  the  amount  indicated 
is  here  the  full  sum  before  commission  has  been 


SOME  HIGHLY  DEVELOPED  TYPES  199 

deducted,  for  this  is  the  amount  which  must  be  deb- 
ited to  the  individual  consignments  even  though  a 
smaller  sum  was  sent  in  cash.  The  next  column  is 
simply  for  the  commission  deducted  on  these  remit- 
tances. The  next  is  for  sums  paid  on  bills  which  we 
owe  for  merchandise  purchased  on  our  own  account; 
and  the  amount  is  the  full  face  of  such  bills;  but  in 
case  we  pay  less  than  the  face,  the  difference  is 
shown  in  the  next  column.  The  expense  column  is 
self-explanatory  to  one  who  understands  the  ele- 
ments of  special-column  usage. 

In  closing  the  credit  side  of  the  cash  book,  we 
must  realize  that  some  items  are  under  this  plan  to 
be  extended  into  the  Sundries  column  and  some  are 
not.  For  instance,  we  have  in  the  case  of  Consign- 
ments debited  Consignments  with  the  full  face  of  the 
bill,  credited  Commission  with  the  deduction,  and 
extended  the  net  amount  of  Cash  into  the  Sundries 
column  because  it  represents  the  net  outgo.  It  is 
obvious,  then,  that  we  must  not  again  extend  into 
the  Sundries  column  the  footing  of  the  Consignments 
column,  for  to  do  so  would  duplicate  the  expendi- 
tures on  this  score.  The  Commission  item,  on  the 
other  hand,  does  not  even  indirectly  represent  cash. 
It  might  have  been  treated  as  a  deduction  from  the 
remittance  on  Consignments,  just  as  the  discounts 
are  treated  as  a  deduction  from  the  amount  to  be 
paid  to  creditors,  but  as  a  matter  of  fact  we  have  not 
so  treated  it  here,  and,  therefore,  must  not  enter  it 
in  any  cash  column  either  on  this  side  of  the  book  or 
on  the  other.  This  Commission  total  is  nothing  but 
a  journal  item  which  must  be  posted  as  a  credit  to 
that  account.    The  other  half  of  this  item — that  is. 


200  ACCOUNTING  AND  AUDITING 

the  debit  to  offset  this  credit — is  included  in  the  Con- 
signments, which  again,  it  will  be  noted,  is  not  a  cash 
item  at  all,  but  merely  a  journal  item  to  be  posted 
directly  without  reference  to  the  cash,  for  the  amount 
of  net  cash  in  connection  with  it  is  entered  in  the 
Sundries  column. 

The  total  of  the  Creditors  column,  however,  is  to 
be  extended  into  the  Sundries  column,  because  we 
shall  later  offset  the  excess,  here  debited  over  the 
amount  actually  paid,  by  the  transfer  of  the  tot^l  of 
the  Discount  column  to  the  other  side  of  the  cash 
book.  The  Shipments  total,  including  the  gain 
brought  from  the  other  side,  is,  of  course,  extended 
into  the  Sundries  column,  for  it  represents  actual  cash 
paid  out  except  for  the  item  of  $6.25,  which  is  offset 
by  a  similar  extension  on  the  other  side. 

The  net  result  of  all  this  apparent  complexity  is 
that  Cash  is  debited  more  than  it  is  credited  by  just 
the  amount  of  net  receipts,  and  that  each  other  ac- 
count is  debited  or  credited  exactly  as  it  should  be. 
Any  sceptic  may  easily  prove  the  correctness  of  the 
cash :  for  he  will  find  the  actual  receipts  to  be 
$973.00;  the  actual  disbursements  to  be  $795.60;  and 
therefore  the  balance  to  be,  as  shown  above,  $177.40. 

The  reader  who  is  interested  to  get  additional 
practice  in  the  handling  of  these  accoimts  is  recom- 
mended to  make  several  changes  so  as  to  make  a  uni- 
form system  out  of  the  unsystematic  form  here 
shown.  Here,  for  instance,  discounts,  both  those 
subtracted  from  bills  paid  by  customers  and  those 
subtracted  from  bills  paid  to  creditors,  are  trans- 
ferred to  the  other  side  of  the  cash  book  in  order  to 
correct  the  overstatement  of  cash:  but  commissions, 


SOME  HIGHLY  DEVELOPED  TYPES  201 

which  bear  the  same  relation  to  Consignments  that 
Discount  does  to  Creditors  and  Customers,  are  not 
here  entered  upon  the  other  side  of  the  cash  book; 
they  are  deducted  directly  from  the  Consignments 
and  the  result  is  extended  into  the  Sundries  column. 
It  is  good  practice  to  alter  the  form  shown  above  so 
as  to  provide  uniformity — to  treat  Commission,  for 
instance,  as  a  contra  item  to  go  upon  the  other  side 
of  the  cash  book  and  be  posted  thence — as  is  done 
with  Discount.  When  this  has  been  done,  it  would 
be  well  to  reverse  the  process  ^nd  treat  Discount  as 
Commission  is  here  treated,  so  that  discounts  shall 
be  deducted  from  the  amount  of  the  bills  and  only  net 
cash  shall  reach  the  Sundries  column.  Another 
change  that  may  be  made  here  to  advantage  is  to 
treat  the  Gain  and  Loss  items  independently  of  Cash,, 
as  if  they  were  journal  items,  and  credit  the  Gain 
and  debit  the  Loss  directly,  as  Commission  is  cred- 
ited on  the  credit  side  of  the  cash  book  shown  above. 
Care  must  be  taken  in  that  case  not  to  neglect  the 
Shipments  portion  of  the  entries.  It  is  desirable  al- 
ways to  provide  that  whatever  plan  is  followed  in 
one  part  of  a  book  shall  be  followed  in  other  parts, 
and  therefore  if  net  amounts  are  to  be  extended  into 
the  Sundries  column  in  one  connection,  they  should 
be  in  all  connections;  or  if  contra  items  are  to  be 
used  in  one  connection,  they  should  be  in  all;  or  if 
any  items  not  strictly  Cash  are  posted  as  if  they  were 
journal  items  independent  of  Cash,  all  such  items 
shall  be  so  treated.  Much  opportunity  for  practice 
in  this  line  is  afforded  by  the  forms  given  above. 
Those  forms  are  not  recommended  as  they  stand,  but 
they  are  serviceable  when  unified  and  simplified. 


202  ACCOUNTING  AND  AUDITING 

It  is  worth  while  now  to  note  certain  bookkeeping 
devices  which  involve  less  a  new  principle  than  a 
modern  development  of  an  old  principle.  These  are, 
primarily,  to  provide  for  small  items  or  infrequent 
items  which  are  not  quite  worth  placing  in  a  ledger 
account  by  themselves. 

The  most  obvious  of  these  is  the  account  com- 
monly called  ^' Petty  Cash."  To  insert  in  the  ordi- 
nary cash  book  small  items  for  telegrams,  cleaning, 
extra  newspapers,  car  fares,  and  things  of  that  sort, 
would  make  considerable  bother — especially  if  these 
items  needed  to  be  posted  one  by  one  to  separate 
accounts.  In  highly  developed  lines  of  business, 
moreover,  it  is  felt  that  for  the  purposes  of  auditing 
and  making  sure  that  all  items  are  properly  ac- 
counted for,  it  is  well  to  make  general  payments 
wholly  through  the  medium  of  checks  drawn  on 
banks.  These  small  items,  however,  could  hardly  be 
provided  for  in  this  way.  It  is  well,  therefore,  to 
keep  in  a  ^^ petty  cash  book,"  so  called,  all  items  not 
paid  by  check,  and  to  limit  such  expenditure  to 
things  of  slight  consequence.  The  method  of  han- 
dling the  petty  cash  may  vary  with  circumstances, 
but  the  most  satisfactory  seems  to  be  what  is  called 
the  ^ impressed  system."  Operations  are  begun  by 
drawing  a  check  for  a  lump  sum  which  is  supposed 
to  supply  the  cashier  with  all  the  ready  money  he 
will  need  for  petty  payments  during  a  considerable 
period  of  time.  This  is  debited  on  the  general  cash 
book  to  Petty  Cash.  As  the  cashier  makes  payments 
from  this  sum  he  keeps  a  record  on  a  subordinate 
book,  or  petty  cash  book,  which,  with  a  number  of 
special  columns,  may  classify  the  items  according 


SOME  HIGHLY  DEVELOPED  TYPES  203 

to  the  accounts  to  which  they  are  ultimately  to  be 
charged.  When  the  cashier  finds  his  supply  of  ready 
cash  low,  he  requests  from  his  superior  a  check  for 
another  sum.  The  amount  of  such  check  is  the  total 
expenses  shown  by  the  petty  cash  book  at  that  time; 
so  that  the  check  drawn  exactly  re-establishes  the 
original  petty  cash  balance.  On  the  general  cash 
book  this  second  sum  is  debited  not  to  Petty  Cash, 
but  to  the  accounts  for  which  the  original  petty  cash 
was  spent.  The  result  of  this  method  is  that  small 
sums  are  kept  in  the  petty  cash  book  until  such  time ' 
as  it  is  worth  while  to  enter  them  in  lump  sums 
on  the  general  cash  book  and  to  meet  them  out  of 
the  bank  balance;  and  the  amount  standing  on  the 
general  ledger  charged  to  Petty  Cash  represents  at 
all  times  the  amount  for  which  the  petty  cashier  is 
responsible — either  the  actual  cash  in  the  petty  cash 
drawer  or  that  sum  plus  expenditures  which  have  not 
yet  been  entered  on  the  general  cash  book. 

Another  method  of  accomplishing  the  same  result 
is  to  debit  Petty  Cash  on  the  general  cash  book  not 
only  for  the  original  check  drawn  for  the  petty  cash 
drawer,  but  for  all  subsequent  payments,  and  then  at 
suitable  intervals,  by  a  journal  entry,  to  debit  the  va- 
rious accounts  for  which  petty  cash  has  been  spent 
and  to  credit  Petty  Cash.  Whenever,  then,  all  the 
petty  cash  book  items  have  been  entered  in  the 
ledger,  through  the  journal,  the  petty  cash  account 
will  show  as  a  balance  the  actual  amount  that  should 
be  on  hand.  The  advantage  of  the  former  method  is 
that  the  check  drawn  for  the  replenishment  of  petty 
cash  always  agrees  in  amount  with  the  expenditure 
entered  on  the  general  cash  book  for  such  petty  cash 


204  ACCOUNTING  AND  AUDITING 

payments.   This,  from  the  auditing  point  of  view,  is 
an  advantage,  for  the  amounts  can  be  checked  item 

bv  item. 

>/ 

Another  device  for  handling  petty  items  is  con- 
cerned with  the  ledger.  In  certain  lines  of  business 
having  but  few  relations  with  customers,  such  as  gas 
companies,  electric  light  companies,  telephone  com- 
panies, etc.,  which  have  usually  debits  to  their. cus- 
tomers at  regular  intervals  for  certain  common  but 
not  numerous  items,  the  ledger  may  be  arranged  in 
horizontal  form  so  that  names  appear  at  the  left  of 
the  page  and  a  series  of  separate  columns  across  the 
page  shows  detailed  charges  for  a  month  or  a  year  or 
whatever  period  is  convenient.  By  the  provision  of 
special  columns  for  credits  and  for  balances,  the  sum- 
mary of  every  account  can  be  seen  at  a  glance,  and 
the  addition  of  any  column  will  show  for  the  page  the 
total  of  each  kind  of  charge — such  as  telephone  rent- 
als, telephone  toUSj  messenger  service,  etc.  These 
totals  may  then  be  compared  with  the  controlling 
account,  which  should  represent  all  such  customers, 
and  with  the  nominal  accounts  which  were  credited 
when  charges  were  made  to  custom^ers.  Such  a  book 
is  usually  called  a  *  tabular  ledger." 

Sometimes  an  account  is  kept  in  the  general 
ledger  with  so-called  ^^ petty  accounts."  Here,  in- 
stead of  separate  accounts  with  each  individual  who 
has  few  and  slight  dealings  with  the  business,  the 
items  for  all  these  individuals  may  be  carried  to  one 
general  account  representing  the  lump  sum — just  as 
Customers  is  kept  for  the  total  of  all  details  shown 
in  a  customers  ledger, — and  yet  no  individual  ac- 
counts need  be  kept  anywhere,  even  in  a  subordinate 


SOME  HIGHLY  DEVELOPED  TYPES  205 

ledger,  with  these  separate  individuals.  The  plan  of 
such  Petty  Accounts  is  usually  that  whenever  a  debit 
or  a  credit  is  made  to  it  (with  a  designation  of  the 
individual  concerned  instead  of  the  account  w^hich  is 
the  other  half  of  the  entry)  the  line  on  the  opposite 
side  is  left  vacant  until  that  item  is  squared;  so  that 
although  ordinarily  on  a  ledger  account  the  credit 
items  would  be  placed  one  directly  under  another, 
regardless  of  any  attempt  to  arrange  them  line  by 
line  opposite  the  debit  items  with  which  they  corre- 
spond, on  this  Petty  Accounts,  if  debits  were  usually 
made  before  credits,  each  credit  would  be  placed 
opposite  the  corresponding  debit,  however  many 
lines  needed  to  be  left  blank  on  the  credit  side.  This 
is  illustrated  by  the  form  given  below. 


Jan.  15 
Jan.  27 
Jan.  30 
Feb.    3 


PETTY    ACCOUNTS 

40 
51 
57 
63 

15  00 
20  00 
17  15 
11154 

Jan.  31 
Feb.  10 

John  Nicholson 

Peter  Ibbetson  51       20|00        Jan.  31      Peter  Ibbetson 

John  Halifax 

George  Tressady  63       11)54        Feb.  10      George  Tressady 


102 


20 


We  may  now  turn  to  something  which  is  a  sort  of 
combination  of  Petty  Accounts,  as  just  indicated,  a 
tabular  ledger,  and  a  controlling  account.  This  is 
common  in  what  is  commonly  called  the  ^^  voucher 
system''  of  bookkeeping.  Under  this  system,  in  its 
full  form,  a  voucher  is  made  out  for  every  debt  owed 
by  the  business,  and  when  payment  is  made  the  pre- 
pared form  is  sent  out  with  a  request  that  it  be 
signed  and  returned.  The  voucher  itself  is  very  little 
concerned  with  the  books,  however,  and  we  may  dis- 
regard its  details.  Indeed,  the  term  'Voucher"  is 
used  unfortunately  in  this  system,  for  a  voucher  is 
really  a  proof  that  money  has  been  paid;  and  the 
term  is  here  used  for  bills  to  be  paid  as  well  as  for 


206  ACCOUNTINCt  AND  AUDITING 

bills  paid.  We  are  concerned  onl}^  with  the  method 
of  handling  a  large  number  of  liabilitirs  witliout 
opening  separate  accounts  in  the  ledger  for  each  firm 
owed.  The  foundation  of  the  bookkeeping  under 
this  system  is  a  voucher  register.  This  is,  in  nature, 
very  much  like  the  accounts  payable  book  described 
in  Chapter  V.  That  book,  however,  is  often  only  an 
auxiliary  book,  and  so  is  not  used  either  to  origi- 
nate postings  or  to  receive  postings.  The  voucher 
register  contains  usually  in  the  first  column  the 
names  of  the  firms  or  the  corporations  to  whom  pay- 
ments must  be  made  for  debts  incurred.  The  second 
column  contains  the  address  of  each.  The  third 
gives  the  number  of  the  voucher  to  be  used  at  the 
time  of  payment.  Next  will  be  shown  the  date  of  the 
bill  for  which  payment  is  to  be  made,  the  terms  of 
such  payment,  and  the  time  when  the  bill  is  due. 
Next  are  columns  for  the  date  of  payment  and  the 
method.  The  next  column  shows  the  amount  to  be 
paid,  and  may  w^ell  be  headed  ^^  Vouchers  Payable, 
Cr."  Then  may  follow  a  number  of  columns  for  ac- 
counts which  are  to  be  ultimately  debited  for  the  debt 
incurred.  If,  for  instance,  the  business  is  that  of  a 
department  store,  a  column  will  be  provided  for  each 
department,  and  when  an  advertising  bill  amounting 
to  $25  comes  in,  it  will  be  entered  at  once  and  per- 
haps $5  of  that  will  be  entered  in  a  special  column 
to  be  debited  to  the  hosiery  department,  $10  in  an- 
other column  for  the  shoe  department,  and  $10  in 
a  third  column  for  the  lace  department.  Entries  are 
made  in  this  register  as  soon  as  bills  are  received  and 
irrespective  of  the  time  when  payment  is  to  be  made. 
No  other  credit  than  this  is  given  on  the  books  for 


SOME  HIGHLY  DEVELOPED  TYPES  201' 

the  firms  to  whom  x)a7ment  is  to  be  made.  The  post- 
ing is  made  to  one  general  account  representing  the 
whole  mass  of  such  debts.  This  is  usually  called 
^* Vouchers  Payable."  Under  this  plan,  then,  the 
amount  of  all  debts  which  have  not  separate  accounts 
in  the  ledger  is  shown  as  the  total  of  this  Vouchers 
Payable  column  in  the  voucher  register,  and  the 
amount  due  to  any  particular  firm  is  shown  by  the 
details  opposite  the  items  bearing  its  name.  At  the 
end  of  each  day,  w^eek,  or  month,  the  items  may  be 
got  upon  the  general  ledger  by  simply  debiting  the 
departmental  accounts  for  the  amount  indicated  for 
each  in  the  separate  columns  in  the  register  and  cred- 
iting Vouchers  Payable  for  the  total.  Whenever 
payments  are  made  in  settlement  of  any  of  these 
debts,  of  course,  Vouchers  Payable  is  debited,  and 
Cash  is  credited,  on  the  cash  book.  At  the  same 
time,  in  the  vouchers  payable  register  the  columns 
for  the  date  of  payment  and  the  method  of  payment 
are  filled  in.  The  balance  of  Vouchers  Payable  in 
the  general  ledger  should  always  agree,  of  course,^ 
with  the  amount  show^n  in  the  register  and  not  indi- 
cated as  paid;  for  as  Vouchers  Payable  has  been 
credited  for  all  debts  (by  the  voucher  register)  and 
has  been  debited  for  all  payments  (by  the  cash 
book),  the  balance  is  the  amount  still  unpaid. 

This  handling  of  vouchers  payable  is  serviceable, 
of  course,  m.ainly  for  dealings  with  firms  who  have 
rather  infrequent  relations  with  the  business;  for 
since  all  the  items  are  handled  individually  assump- 
tion is  always  made  that  each  bill  will  be  paid  by 
itself  and  will  not  be  combined  with  others  in  a  set- 
tlement of  the  lump.    If  there  is  outstanding  more 


308  ACCOUNTING  AND  AUDITING 

than  one  debt  with  any  firm  at  the  same  time,  there 
is  under  this  system  no  way  of  finding  the  total  obli- 
gation to  that  firm  except  by  going  through  the  reg- 
ister and  discovering  that  there  are  several  items  due 
to  it.  In  other  words,  under  this  vouchers  payable 
system  there  is  no  indexing,  and  the  possibility  of 
indexing,  as  we  saw  long  ago,  is  one  of  the  chief  ad- 
vantages of  a  ledger. 

Often  the  managers  of  a  business  wish  to  withhold 
from  their  bookkeepers  information  about  its  inner 
relations.  This  can  be  accomplished  by  providing  a 
separate  private  set  of  books — but  without  duplica- 
ting labor.  Indeed,  comparatively  few  kinds  of  trans- 
actions need  to  be  known  to  the  general  bookkeepers. 
The  numerous  transactions,  which  require  much  labor 
for  entry,  are  purchases,  or  manufacturing,  sales, 
payments  for  purchases,  collections  from  sales,  and 
payments  for  expense.  These,  of  course,  the  general 
bookkeepers  will  enter  on  the  books.  Investment  of 
capital,  borrowings,  salaries  of  managers,  division  of 
profits  among  partners,  payments  of  interest,  taxes, 
and  numerous  other  items,  however,  are  usually  so 
infrequent  that  entries  for  them  may  be  made  by  a 
proprietor  or  confidential  bookkeeper  in  the  private 
cash  book,  private  journal,  and  private  ledger.  Such 
an  arrangement,  moreover,  does  not  preclude  the  pos- 
sibility of  a  trial  balance  for  the  general  ledger  or 
for  the  private  ledger.  The  device  of  a  controlling 
account  makes  possible  the  complete  separation  of 
these  two  sets  of  books  without  robbing  either  set  of 
any  desirable  figures. 

The  method  may  be  summarized  briefly.  On  the 
general  books  any  items  of  assets  received  from 


SOME  HIGHLY  DEVELOPED  TYPES  S09 

sources  not  shown  on  the  general  ledger  are  credited 
to  an  account  called  ^* Private  Ledger."  The  details 
show  on  the  private  ledger — as  details  of  Accounts 
Receivable  show  on  the  sales  ledger.  When  cash  is 
received,  the  general  bookkeepers  need  not  know 
whether  it  comes  from  investment  of  partners,  from 
loans,  or  from  conversion  of  other  assets  not  known 
to  them.  Similarly,  any  outgo  to  destinations  not 
indicated  on  the  general  ledger  is  debited  to  Private 
Ledger ;  and  no  one,  unless  he  has  access  to  the  pri- 
vate ledger  or  to  checks  drawn,  can  know  whether 
such  outgo  is  for  interest  on  loans,  for  partners'  sal- 
aries, for  payment  on  debts,  for  partners'  withdrawal 
of  capital,  for  payment  of  expenses,  or  for  partners' 
withdrawal  of  profits.  The  private  books,  however, 
show  all  details.  If  a  separate  bank  account  is  kept 
for  the  private  transactions,  moreover,  private  re- 
ceipts and  pajonents  need  not  appear  on  the  general 
books  even  for  the  controlling  account — except  when 
transfers  are  made  from  the  private  bank  account  to 
the  general,  or  vice  versa.  The  general  books  need 
not  be  complete.  They  must  balance,  of  course,  but 
all  matters  not  of  concern  to  the  general  bookkeepers 
are  lumped  in  the  private  ledger  account.  A  big  real 
estate  purchase,  for  example,  would  involve  a  debit 
to  Real  Estate  and  a  credit  to  Cash  in  the  private 
books ;  but  since  it  does  not  affect  anything  that  con- 
cerns the  general  books,  it  does  not  affect  even  the  pri- 
vate ledger  account  in  the  general  ledger. 

The  private  books,  on  the  other  hand,  may  show 
the  summary  of  the  whole  business,  and  therefore 
may  include  all  transactions  of  the  general  books,  or 
they  may  show  only  net  results.    In  the  latter  case, 

A  &  A-14 


m  ACCOtTNTING  AND  AUDITING 

the  private  ledger  may  have  an  account  entitled  '*  Gen- 
eral Ledger"  to  serve  as  an  explanation  when  items 
are  taken  over  from  the  general  books  into  the  private 
books.  A  trial  balance  is  then  possible  for  the  private 
books  without  the  details  of  the  general  books.  If  in 
making  up  the  private  trial  balance,  moreover,  the 
bookkeeper  substitutes  the  individual  items  on  the 
general  trial  balance  for  his  own  General  Ledger  ac- 
count, the  trial  balance  of  the  private  ledger  will  be 
complete  for  the  business  as  a  whole.  If,  on  the  other 
hand,  it  is  desired  to  show  on  the  private  ledger  itself 
a  summary  of  the  accounts  on  the  general  ledger  (in- 
stead of  an  adjustment  account  as  just  described),  the 
totals  of  general  books  may  be  posted  directly  to  the 
private  ledger  as  well  as  to  the  general  ledger ;  so  that 
the  total  of  the  purchase  book,  for  illustration,  will  be 
posted  as  a  debit  to  Purchases  and  a  credit  to  Ac- 
counts Payable  in  both  books.  It  is  likely  to  be  sim- 
pler, however,  to  carry  to  the  private  books  only  items 
which  affect  private  accounts,  making  adjustment 
through  the  account  called  *^ General  Ledger,"  as  pre- 
viously described,  and  to  use  the  general-ledger  trial 
balance  for  ascertaining  details. 

This  device  for  the  separation  of  private  and  gen- 
eral matters  is  capable  of  many  variations;  but  it 
makes  possible  the  employment  of  an  army  of  book- 
keepers without  opening  one's  affairs  to  common 
knowledge.  If  inventories  are  kept  private,  even  a 
knowledge  of  both  purchases  and  sales  fails  to  disclose 
gross  profits,  and  net  profits  are  still  further  removed 
from  disclosure. 

Another  interesting  use  of  a  controlling  account  is 
in  connection  with  business  transacted  in  foreign  cur- 


SOME  HIGHLY, DEVELOPED  TYPES  M 

rencies.  If  a  pound  sterling  were  always  equivalent 
to  the  same  sum  in  dollars  and  cents,  it  would  matter 
little  if  all  such  foreign  items  were  converted  imme- 
diately into  American  figures ;  but  rates  of  exchange 
are  constantly  changing,  and  the  price  actually  paid 
for  goods  bought  or  sold  abroad  may  not  agree  with 
the  nominal  equivalent  of  the  bill.  It  is  desirable, 
moreover,  that  the  books  of  buyer  and  seller  shall 
agree.  It  is  customary  when  bills  are  expressed  in 
foreign  currency,  therefore,  to  keep  separate  pur- 
chase or  sales  books  and  purchase  or  sales  ledgers 
for  foreign  trade  and  keep  them  in  the  original  cur- 
rency. Since  the  amounts  must  be  included  in  the 
general  books,  however,  and  in  American  currency,  a 
controlling  account  is  kept  in  the  general  ledger,  and 
the  amount  is  shown  in  both  currencies — that  is,  the 
ruling  provides  two  sets  of  money  columns.  When 
goods  are  bought,  therefore,  they  are  credited  in  the 
foreign  purchase  book  and  the  foreign  purchase 
ledger  at  the  foreign  price ;  when  the  total  is  carried 
to  the  controlling  account  the  amount  is  converted 
into  American  currency  at  the  nominal  exchange 
rate  (say  $4,86  2/3  for  a  pound  sterling),  and  both 
amounts  are  posted  to  the  general  ledger.  When 
payments  are  made,  on  the  other  hand,  the  control- 
ling account  is  debited  in  American  currency  for  the 
amount  actually  paid  for  the  bill  of  exchange,  the 
posting  to  the  general  ledger  is  not  only  for  the 
amount  actually  paid  in  American  currency,  but  for 
the  aniount  of  foreign  currency  which  the  bill  ac- 
tually covers,  and  the  posting  in  the  foreign  pur- 
chase ledger  is  for  the  amount  of  foreign  currency 
vemitted.     This  device  allows  the  books  to  show  at 


^1^  ACCOUNTING  AND  AUDITING 

all  times  the  balance  due  in  foreign  currency — not 
only  on  the  subordinate  ledger,  but  also  on  the  gen- 
eral ledger, — the  actual  cost  of  remittances  as  com- 
pared with  the  nominal  equivalent,  and  hence,  of 
course,  the  profit  or  loss  on  exchange.  As  often  as 
desired,  the  controlling  account. may  be  closed;  then 
the  difference  between  the  nominal  exchange  figure, 
for  paid  bills  and  the  amount  actually  paid  on  them 
will  be  transferred  to  Profit  and  Loss. 


CHAPTER  Vm 

THE  PECULIAEITIES  OF  COEPORATION  ACCOUNTS 

In  the  accounting  of  corporations  certain  features 
are  unlike  anything  that  is  possible  under  a  single 
proprietorship  or  a  partnership.  It  is  well  at  this 
point  to  study  these  with  some  care,  for  most  busi- 
ness operations  are  nowadays  carried  on  under  cor- 
porate ownership. 

Among  accounts  peculiar  to  corporations  is  Divi- 
dends. This  is  of  use,  of  course,  only  where  there  is 
an  issue  of  capital  stock.  The  method  of  distributing 
profits  in  a  corporation  is  to  carry  to  Dividends  the 
amount  of  profits  which  the  directors  have  voted  to 
distribute,  and  to  enter  it,  of  course,  as  a  credit;  for 
since  the  profits  must  stand  on  the  credit  side  of  the 
profit  and  loss  account,  and  this  amoimt  is  simply 
transferred  to  Dividends,  it  must  appear  on  the  same 
side.  A  simple  journal  entry  debits  Profit  and  Loss 
and  credits  Dividends — explaining,  of  course,  why 
the  entry  is  made.  Dividends  are,  of  course,  a  lia- 
bility of  the  corporation  until  they  are  paid.  When 
they  are  paid.  Dividends  is  debited.  Cash  is  credited, 
and  so  the  dividend  account  is  balanced. 

The  most  important  distinction  between  the  ac- 
counts of  single  proprietorships  and  partnerships,  on 
one  hand,  and  corporations,  on  the  other,  lies  in  the 
capital  stock  account.  This  is  always  merely  a  con- 
trolling account  and  represents  the  lump  sum  of  the 

213 


214  ACCOUNTING  AND  AUDITING 

holdings  of  all  stockholders.  It  is  obviously  unneces- 
sary to  enter  on  the  general  ledger  the  names  and 
shares  of  individual  stockholders,  for  each  share  of 
stock  is  represented  by  a  certificate  held  by  the 
owner  and  sufficiently  indicating  his  title.  One  cer- 
tificate may  cover  all  the  holdings  of  one  person,  and, 
therefore,  may  cover  many  shares;  but  it  is  possible 
for  one  person  to  have  many  certificates,  each  for  a 
small  lot  of  shares,  so  that  he  may  sell  a  part  of  his 
holding  without  affecting  the  rest.  In  order  to  keep 
run  of  the  holdings  of  stock,  so  that  the  corporation 
may  know  not  only  who  is  entitled  to  vote  and  to 
whom  dividends  should  be  paid,  but  also  on  whom 
calls  may  be  issued  for  assessments  in  case  any  are 
necessary,  a  stock  ledger  or  stockholders'  ledger  is 
kept  to  indicate  exactly  wh^t  is  the  holding  of  each 
person.  This  is  purely  a  subordinate  ledger.  The 
total  credit  balance  of  the  individual  stockholders' 
accounts  in  the  stock  ledger  must  agree,  of  course, 
with  the  total  credit  of  the  capital  stock  account  in 
the  general  ledger. 

The  process  by  which  the  credits  to  individual 
stockholders  are  established  is  in  many  cases  inter- 
esting. If  the  total  capital  stock  of  a  corporation 
were  issued  at  once  and  the  full  amount  of  cash  were 
received  immediately  in  return,  the  bookkeeping 
would  be  simply  a  debit  to  Cash,  and  a  credit  to  Capi- 
tal Stock,  for  that  amount.  This,  however,  is  not 
the  common  operation.  Usually  new  stock  may  be 
paid  for  by  installments;  often  the  amount  to  be 
paid  is  either  more  or  less  than  the  par  value;  stock  is 
often  issued,  moreover,  in  return  for  property,  or  in 
payment  for  a  business  bought  outright  by  the  corpo- 


COEPORATIOK  ACCOUNTS  215 

ration.  We  have  sometimes  to  provide,  then,  for  in- 
stallment subscriptions,  sometimes  for  premium  or 
discount,  and  sometimes  for  the  transfer  of  property 
and  good  will.  All  three  of  these  complications,  in- 
deed, may  arise  in  connection  with  one  issue.  They 
must,  therefore,  be  examined  in  some  detail. 

Let  us  take  first  the  issue  of  stock  on  installments 
in  cases  where  the  full  face  value  is  ultimately  to  be 
paid.  In  order  to  keep  run  of  the  amount  paid  on 
each  installment,  it  is  desirable  in  this  sort  of  case  to 
open  in  the  general  ledger  an  account  with  each  of 
the  installments.  Let  us  suppose  that  1,000  shares 
of  stock  are  to  be  issued  at  $100  a  share,  and  that 
payment  is  to  be  made  in  four  equal  installments. 
The  stock  itself  cannot  be  issued  until  all  install- 
ments have  been  paid,  and  it  is  undesirable  to  enter 
on  the  books  a  credit  to  Capital  Stock  until  the  stock 
is  actually  issued;  and  yet  we  must  make  some  credit 
to  o:ffset  the  debits  for  the  installment  subscriptions 
which,  as  promises  to  pay  sums  to  the  business,  are 
assets  similar  in  nature  to  bills  receivable.  Since 
the  promise  of  the  business  to  deliver  stock,  when  all 
installments  are  paid,  has  created  the  possibility  of 
these  subscriptions,  an  account  for  stock  subscribed 
is  credited.  The  common  entry  when  these  subscrip- 
tions are  received,  then,  is  as  follows : 

Installment  Subscription  No.  1  25,000 

Installment  Subscription  No.  2  25,000 

Installment  Subscription  No.  3  25,000 

Installment  Subscription  No.  4  25,000 

To  Stock  Subscribed  100,000 

An  additional  advantage  in  this  Stock  Subscribed 
is  that  since  Qs^ve  must  be  taken  that  not  more  capital 


216  ACCOUNTING  AND  AUDITING 

stock  is  promised  to  be  issued  than  is  authorized  by 
law,  it  is  desirable  to  know  what  amount  is  already 
pledged.  The  difference  between  this  and  the  sum 
authorized  is  available  for  further  subscription  or  for 
issue  by  some  other  method.  Only  by  establishing 
this  account  is  it  possible,  without  much  hunting 
through  the  books,  to  show  properly  just  what  is  the 
margin  of  unpledged  stock.  Some  bookkeepers  in 
such  a  case  credit  Capital  Stock  directly  for  the 
amount  subscribed  and  then  by  a  new  entry  debit 
Treasury  Stock  and  credit  Unsubscribed  Stock  for 
the  balance  unpledged.  This  is  misleading,  for,  as 
will  be  shown  later,  the  term  *  treasury  stock" 
should  be  reserved  for  another  sort  of  thing. 

When  one  of  these  installments  is  paid  the  entry 
is  simple: 

Cash  25,000 

To  Installment  Subscription  No.  1  25,000 

When  all  these  have  been  paid,  so  that  Cash  is  deb- 
ited for  the  full  value  of  the  stock  and  the  install- 
ment accounts  are  closed,  the  stock  itself  must  be 
issued.    The  entry  for  the  issue  will  be  as  follows : 

Stock  Subscribed  100,000 

To  Capital  Stock  100,000 

This  entry  balances  Stock  Subscribed,  and  the  net 
result  of  all  the  entries  is  a  debit  to  Cash  and  a  credit 
to  Capital  Stock^ — which  is,  as  we  have  seen,  .just 
what  the  entry  would  have  been  if  all  the  capital 
stock  had  been  issued  in  a  lump  sum  for  cash. 

A  complication  arises  in  the  handling  of  these 
installment  subscriptions  in  case  transfers  are  made 
before  stock  is  fully  paid.    It  may  happen  that  a 


CORPORATION  ACCOUNTS  217 

subscriber  desires  to  surrender  his  subscription  to 
another,  or  to  purchase  another's  right  to  stock.  In 
that  case  he  is  not  only  selling  a  right,  but  is  trans- 
ferring to  another  an  obligation;  for  he  is  not  only 
selling  the  right  to  receive  stock,  but  is  transferring 
an  obligation  to  pay  the  unpaid  portion  of  the  sub- 
scription. On  the  books  of  the  corporation  it  is  nec- 
essary to  show,  then,  for  each  installment,  just  what 
portion  has  been  paid,  and,  when  any  transfer  is 
made,  just  how  much  obligation  is  taken  by  the  pur- 
chaser of  the  right.  This  is  done  on  an  installment 
ledger.  On  the  next  page  will  be  found  a  convenient 
form 


218 


ACCOUNTING  AND  AUDITING 


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COKPORATION  ACCOUNTS  219 

It  is  necessary  to  note,  before  one  can  under- 
stand this  installment  ledger,  that  whenever  a  right 
is  transferred  a  new  certificate  must  be  issued,  and 
in  this  case  the  certificate  is  not  for  ownership  of 
capital  stock,  but  is  simply  a  receipt  for  the  payment 
of  a  certain  proportion  of  the  full  subscription.  If 
a  man  sells  all  his  holdings,  he  will  simply  surrender 
the  old  certificate  and  request  that  a  new  one  be 
issued  to  the  new  holder.  If,  however,  he  transfers 
only  a  portion  of  his  holdings,  the  old  certificate  must 
be  surrendered  and  tw^o  new  ones  issued  in  its  place, 
one  of  which  will  then  be  transferred  to  the  pur- 
chaser. The  explanation  on  the  installment  ledger  in 
connection  with  all  such  transfers  should  indicate, 
therefore,  the  surrender  of  the  old  certificate  on  the 
credit  side  and  the  issue  of  the  two  new  ones  on  the 
debit  side;  then  on  the  credit  side  will  be  indicated 
the  surrender  of  one  of  the  new  certificates  to  the 
purchaser.  On  the  credit  side  of  this  ledger,  there- 
fore, two  sets  of  columns  will  be  necessary;  one  of 
these  will  show  the  actual  payment  of  installments, 
which,  of  course,  will  be  each  for  a  certain  percent- 
age— say  twenty-five  per  cent. —  of  the  total  amount 
subscribed;  and  the  other  will  show  the  surrender  of 
shares  partially  paid.  In  the  account  shown  above, 
the  subscription  is  recorded  as  of  February  15;  on 
March  1  the  first  installment  of  25%  is  paid;  on 
March  15  a  subscription  of  50  shares,  made  by  John 
Brown,  on  which  the  first  installment  has  already 
been  paid,  is  transferred  to  this  account;  on  March 
20,  25  shares  are  sold  to  David  Grieve,  by  exchanging 
certificate  No.  13  for  two  certificates  and  transfer- 
ring one  of  them;  on  April  1,  the  second  installment 


220  ACCOUNTING  AND  AUDITING 

is  paid  on  all  subscriptions  now  belonging  to  this 
account.  At  all  times  a  balance  of  the  total  debits 
and  credits,  in  dollars  and  cents,  shown  on  any  in- 
stallment account  will  indicate  the  balance  still  un- 
paid, and  a  balance  of  the  debit  and  credit  shares  will 
show  the  number  of  shares  on  which  the  person  is 
still  responsible  to  make  payment.  In  the  case  above, 
for  instance,  a  balance  struck  on  April  2  will  show 
liability  for  200  shares  and  $17,500,  and  credit  for  75 
shares  and  $11,250,  or  a  balance  of  125  shares  and 
$6,250, — which  is  as  it  should  be,  for  it  is  50%  on  125 
shares. 

The  stock  ledger  is  of  similar  form  except  that  it 
needs  no  provision  for  the  payment  of  installments. 
The  balance  of  the  stock  ledger,  however,  will  always 
be  upon  the  credit  side,  for  the  stockholder  has  en- 
trusted property  to  the  business;  whereas  the  bal- 
ance of  the  installment  ledger  will  always  be  on  the 
debit  side,  for  until  the  subscriber  has  made  full 
payment,  he  is  still  responsible  to  the  corporation  on 
account  of  his  promise. 

If  the  stock  is  issued  in  payment  for  a  business 
taken  over  by  the  corporation,  the  entries  will  not 
necessarily  be  very  different,  but  they  may  require 
an  allowance  of  the  difference  between  the  present 
worth  of  the  old  business,  as  shown  by  the  books,  and 
the  amount  of  stock  to  be  issued  in  payment  for  it. 
If,  for  instance,  the  corporation  is  to  succeed  to  an 
old  business,  and  will  continue  with  the  same  books 
-^as  it  naturally  will  do  if  it  takes  over  all  the  prop- 
erty and  assumes  all  the  debts, — ^it  may  give  in  capi- 
tal stock  considerably  more  than  the  present  worth 
of  the  old  business  as  shown  by  the  balance  sheet ;  for 


CORPORATIOiSr  ACCOUNTS  tn 

the  old  business  may  have  such  high  earnings  that  it 
is  worth  a  premium.  It  is  not  customary  in  the  books 
of  a  proprietorship  to  write  up  the  value  of  the  assets 
merely  because  they  happen  to  produce  large  earn- 
ings. If  the  net  assets  of  such  a  business  are  $100,000 
and  the  net  profits  are  $15,000  a  year,  this  business  is 
regularly  earning  fifteen  per  cent.,  and,  if  taken  over 
by  a  corporation,  its  proprietors  would  probably  re- 
ceive more  than  $100,000  in  capital  stock;  for  a  cor- 
poration would  hardly  desire,  usually,  to  pay  an  an- 
nual dividend  of  fifteen  per  cent.  Capital  stock  would 
be  issued  of  such  an  amount  as  to  produce  a  dividend 
of  possibly  seven  and  a  half  per  cent.  In  that  case, 
if  it  were  assumed  that  under  the  corporation  the 
business  would  earn  as  much  as  previously,  the  cap- 
italization of  the  old  business  would  be  put  at  $200,- 
000,  for  seven  and  a  half  per  cent,  on  $200,000  w^ould 
equal  the  $15,000  expected  as  an  earning.  If  this 
business  were  to  be  taken  over  by  a  corporation  al- 
ready engaged  in  operations,  and  it  had  been  the 
previous  experience  of  this  corporation  that  it  could 
pay  seven  and  a  half  per  cent,  dividends,  the  owners 
of  the  business  now  taken  over  would  hardly  be  will- 
ing to  make  a  sale  unless  they  could  be  guaranteed 
practically  as  high  profits  as  they  had  been  receiving 
in  the  past,  and,  therefore,  on  the  assumption  that 
the  corporation  would  not  pay  more  than  seven  and 
a  half  per  cent,  dividends,  they  could  exact,  from 
those  who  wished  to  buy  them  out,  capital  stock  to 
the  amount  of  $200,000.  It  is  actually  true  in  this 
case  that  w^hat  is  called  the  ^^good  will"  of  the  busi- 
ness is  $100,000;  for  since  the  present  value  of  its 
tangible  assets  is  only  $100,000,  and  yet  its  earnings 


m  ACCOUNT^IKG  AISTD  AtTDITINO 

are  equivalent  to  seven  and  a  half  per  cent,  on  $200,- 
000,  the  extra  $100,000 — due  to  the  excess  of  profits 
over  the  normal  rate  on  its  investment — represents 
the  value  of  its  superior  organization  or  its  reputa- 
tion, and  any  corporation  taking  over  this  enterprise 
can  afford  to  pay  $100,000  for  the  right  to  use  its 
name  and  privileges  with  customers  who  have  been 
accustomed  to  buy  of  it,  with  dealers  who  have  sold 
it  goods  and  granted  it  credit,  with  the  labor  which  it 
has  employed,  and  with  others  who  may  help  to  util- 
ize what  it  has  built  up  in  the  past.  We  must,  then, 
if  we  are  going  to  transfer  to  the  corporation  the 
books  of  the  firm,  bring  up  the  assets  to  $200,000  in 
order  that  when  the  stock  is  issued  the  assets  sur- 
rendered may  exactly  offset  it.  The  method  would 
be  simply  to  debit  Good  Will  $100,000  and  credit  the 
proprietors;  for  this  amount,  though  real,  has  not 
been  previously  entered  to  their  credit;  the  valua- 
tions have  not  been  based  upon  earning  capacity,  as 
it  is  now  desired  that  they  shall  be,  but  upon  cost. 
When  we  have  made  this  entry,  the  proprietors  stand 
credited  with  $200,000,  for  their  previous  net  credit 
was  $100,000.  When  stock  is  issued  to  them,  on  the 
transfer  of  their  title  to  the  business,  another  entry 
will  debit  the  proprietors  and  credit  Capital  Stock 
for  $200,000.  This  will  balance  the  proprietors'  ac- 
counts and  show  that  they  have  no  further  interest, 
as  individuals,  in  the  business.  Their  portion  of  the 
business  is  simply  that  of  stockholders  holding  two 
thousand  shares.  Then  entries  may  be  made  in  the 
books  exactly  as  if  no  transfer  had  been  made  to  the 
corporation;   for  the  assets  including  the  good  will 


CORtOBATION  ACCOUNTS  M 

are  now  the  assets  of  the  corporation-,  and  its  liabili- 
ties are  the  liabilities  of  the  corporation. 

We  come  now  to  the  situation  when  stock  is  sold 
for  more  or  less  than  par.  It  is  obvious  that  if  shares 
of  stock  with  a  par  value  of  $100  are  sold  for  $125  in 
cash,  this  amount  of  cash  realized  is  capital  just  as 
much  as  if  the  $125  had  been  invested  by  a  proprie- 
tor. In  no  sense  can  this  extra  $25  be  considered 
profit  to  the  corporation,  for  the  $25  is  just  as  much 
invested  property,  which  the  corporation  may  use  in 
operations  to  get  profits,  as  is  the  $100  which  is  rep- 
resented in  the  par  value  of  the  stock.  A  stockholder 
who  has  bought  stock  at  par  and  sells  it  for  $25  pre- 
mium is,  of  course,  making  that  $25  as  profit,  but 
with  that  the  corporation  has  nothing  to  do;  and  we 
are  concerned  only  with  the  premium  which  the  cor- 
poration itself  receives  on  stock  issued  by  itself  at 
more  than  par.  In  a  single  proprietorship  or  a  part- 
nership this  premium,  or  its  equivalent,  would  be  car- 
ried to  the  credit  of  the  partners'  accounts,  but  since 
in  a  corporation  we  have  no  partners'  accounts  and 
can  represent  proprietors'  shares  only  in  the  capital 
stock  account  at  par,  we  must  indicate  the  premium 
in  this  case  as  an  additional  sum  belonging  to  stock- 
holders but  not  represented  on  the  face  of  the  shares 
of  capital  stock  issued.  Surplus,  as  we  have  already 
seen,  is  nothing  but  an  undivided  portion  of  capital, 
and  it  is  quite  as  much  so  when  it  consists  of  original 
investment  paid  in  by  stockholders  as  when  it  con- 
sists of  accumulated  profits  from  the  operations  of 
the  business.  National  banks  are  by  law  required  to 
establish  a  surplus  of  twenty  per  cent,  of  their  capi- 
tal stock,  and  the  law  prescribes  that  out  of  each 


%U  ACCOUNTING  AND  AUDITING 

year's  earnings  a  certain  percentage  shall  be  laid 
aside  and  placed  in  the  surplus  until  this  required 
twenty  per  cent,  has  been  accumulated;  but  many 
banks  begin  business  with  a  surplus  already  on  hand 
through  the  medium  of  stock  issued  originally  at  a 
premium.  When,  therefore,  stock  is  issued  at  a  pre- 
mium, we  have  not  only  to  carry  it  to  Surplus,  but  to 
do  so  under  a  name  that  will  show  that  it  must  not  be 
distributed  as  profits.  A  simple  entry  covers  the  sit- 
uation, as  follows: 

Cask  125,000 

To  Capital  Stock  100,000 

Capital  Surplus  25,000 

The  situation  would  not  be  materially  altered  if 
the  cash  were  collected  in  installments,  and  not  in 
one  lump  sum  as  here  indicated.  If,  for  instance,  the 
stock  were  to  be  paid  for  by  five  installments,  the 
entry  would  read: 

Installment  Subscription  No. 
Installment  Subscription  No. 
Installment  Subscription  No. 
Installment  Subscription  No. 
Installment  Subscription  No. 
To  Stock  Subscribed 
Capital  Surplus 

When  all  such  installments  are  paid,  the  entry  will 
be,  as  before, 

Stock  Subscribed  100,000 

To  Capital  Stock  100,000 

This  closes  out  Stock  Subscribed. 

When  stock  is  sold  at  a  discount  a  somewhat  dif- 
ferent situation  is  to  be  faced.  Under  the  law  if 
stockholders  have  not  paid  the  full  value  of  their 


1 

25,000 

2 

25,000 

3 

25,000 

4 

25,000 

5 

25,000 

100,000 

25,000 

CORPORATION  ACCOUNTS  225 

stock  they  may  be  legally  held  liable  for  the  debts 
of  the  corporation  up  to  the  amount  of  the  unpaid 
portion  of  their  subscriptions.  If,  therefore,  capital 
stock  is  issued  by  the  corporation  at  less  than  par,  a 
liability  still  stands  against  each  stockholder  for  the 
deficiency  in  his  subscription,  and  if  the  corporation 
goes  into  insolvency  he  must  pay.  Usually  stock- 
holders do  not  desire  such  a  liability  to  stand  against 
them,  and,  consequently,  they  endeavor  to  make  the 
stock  fully  paid.  Unfortunately,  many  organizers  of 
corporations  attempt  to  do  this  by  falsification  upon 
the  books,  but  sometimes  the  process  is  legitimate,  as 
we  shall  see.  The  desire  is  to  provide  that  the  stock 
issued  shall  be  represented  upon  the  books  either 
truly  or  fictitiously  as  fully  paid,  and  yet  to  make  it 
possible  to  sell  stock  at  a  discount.  The  method  of 
doing  this  is  commonly  for  the  organizers  of  the  com- 
pany to  issue  stock  to' themselves  at  par  in  return  for 
assets  which  they  surrender  to  it,  and  then  to  donate 
some  of  that  stock  back  to  the  corporation.  On  the 
books,  therefore,  the  capital  stock  appears  to  have 
been  once  fully  paid,  because  it  was  given  in  ex- 
change for  assets;  and  since  it  was  donated  to  the 
corporation  and  has  cost  the  corporation  nothing,  it 
may  now,  once  fully  paid  up,  be  even  given  away  by 
the  corporation  if  the  directors  find  good  reason  for 
so  disposing  of  it,  or — and  this  is  the  desired  thing — 
it  may  be  sold  at  a  discount.  In  such  a  case  it  is  ob- 
vious that  if  the  corporation  goes  into  insolvency  and 
the  creditors  can  show  that  the  stock  was  originally 
issued  on  a  fictitious  valuation  of  property,  the  stock- 
holders are  still  liable  for  the  deficiency.  The  ad- 
vantage of  this  method,  from  the  point  of  view  of  the 
▲  ik  A-ii 


226  ACCOUNTING  AND  AUDITING 

dishonest  organizer,  is  that  the  burden  of  proof  is 
placed  upon  the  creditor;  for  unless  he  can  prove  the 
overvaluation  of  assets,  the  books,  showing  that  full 
value  was  given,  defend  the  stockholder  against  as- 
sessment. 

Under  some  circumstances  there  may  be  a  dona- 
tion of  stock  to  the  corporation  when  absolutely  no 
taint  of  fraud  attaches  to  it.  If,  for  instance,  the 
organizers  are  satisfied  that  the  property  which  they 
hold  is  absolutely  good  and  is  sure  to  bring  in  large 
earnings,  but  know  that  they  can  hardly  convince 
others  of  the  value  of  this  property,  they  realize  that 
others  will  buy  the  stock  in  the  corporation  only  at 
a  discount.  They  may  then  issue  stock  at  the  equiva- 
lent of  what  they  know  to  be  the  actual  value  of  the 
property  and  donate  some  of  it  back  to  the  corpora- 
tion to  enable  the  corporation  to  sell  it  at  a  discount; 
for,  as  we  have  already  seen,  if  the  stock  has  once 
been  fully  paid,  it  may  be  sold  at  any  reasonable  price 
without  liability  for  assessment.  (The  national  bank 
law,  however,  makes  stockholders  liable  for  an  as- 
sessment equal  to  the  par  value  of  their  stock,  in  case 
of  insolvency,  even  when  the  full  par  value  has  once 
been  paid.)  It  may  at  first  seem  as  if  it  would  be  as 
well  for  the  original  subscribers  in  such  a  case  to  take 
their  stock  at  a  premium,  say  at  125 — so  that  they 
would  get  eight  shares  for  a  thousand  dollars — as  to 
take  it  at  par  and  then  donate  some  of  it — say  two 
shares — ^back  to  the  company;  for  then  the  company 
would  have  unsubscribed  shares  available  for  it  to 
sell  without  increasing  its  capitalization.  That  would 
be  true  if  stock  could  be  sold  at  par;  but  the  purpose 
of  this  public  sale  of  stock  is  to  raise  working  capital, 


CORPORATION  ACCOUNTS  227 

and  the  stock  must  be  sold  for  what  it  will  bring. 
Those  who  have  faith  in  the  business  must  induce 
others  to  subscribe,  and  it  is  a  fact  of  human  nature 
that  men  look  for  low  prices — even  when  the  value  is 
exactly  proportionate  to  the  price.  Even  though  it 
were  true  that  the  profits  would  be  just  in  propor- 
tion to  the  capital,  so  that  a  man  could  as  well  af- 
ford to  pay  par  (and  get  eight  per  cent,  dividend  on 
his  stock)  as  to  pay  75  (and  get  six  per  cent.),  he 
would  be  more  likely  to  buy  at  75  than  at  par.  For 
practical  reasons,  therefore,  this  method  of  making 
stock  not  only  legally  but  actually  fully  paid  is  some- 
times worth  while.  This  is  the  only  honest  method 
of  providing  for  the  original  sale  of  stock  at  a  dis- 
count. Stock  is  sometimes  sold  by  outsiders  at  a 
discount  when  it  has  not  ever  been  actually  sold  at 
par;  but  in  such  cases  it  was  originally  issued  in  re- 
turn for  what  were  ostensibly  adequate  services  ren- 
dered— such  as  fees  for  promotion,  for  underwriting 
or  guaranteeing  the  sale  of  bonds  or  stock.  Some  of 
these  transactions  in  the  past  have  been  open  to  grave 
suspicion  as  devices  to  evade  the  law,  but  unfortu- 
nately the  burden  of  proof  is  laid  on  the  objector. 
The  tendency  nowadays  is  to  hold  corporations  more 
strictly  responsible  for  their  acts;  for  the  community 
is  coming  to  realize  that  as  stockholders  are  relieved 
from  some  responsibilities  which  attach  to  partners, 
they  must,  in  compensation,  be  held  strictly  respon- 
sible for  fulfilling  other  duties  falling  on  them. 

The  entries  for  stock  sold  at  a  discount  are  inter- 
esting. The  proper  bookkeeping  term  to  indicate 
stock  which  has  once  been  fully  paid  and,  therefore, 
belongs  to  the  corporation  to  treat  as  it  pleases,  is 


228  ACCOUNTING  AND  AUDITING 

'treasury  stock."  This  term,  however,  may  include 
stock  which  the  corporation  has  itself  purchased  in 
the  market  from  its  own  issue,  as  well  as  stock  do- 
nated to  it.  It  seems  preferable,  therefore,  in  the 
case  of  a  donation  of  stock,  to  use  the  title  '*  Donated 
Stock, ' '  for  then  there  can  be  no  question  as  to  origin. 
Let  us  suppose  that  a  corporation,  with  stock  issued 
at  $100,000,  in  exchange  for  a  business  actually  or 
fictitiously  valued  at  $100,000,  receives  back  from  its 
stockholders  $20,000  of  that  stock,  to  be  sold  for  the 
benefit  of  the  treasury — that  is,  as  a  means  of  raising 
so-called  working  capital,  read}^  money  to  supply  it 
with  the  means  of  hiring  labor,  buying  materials,  etc. 
The  original  entry  would  have  read,  possibly, 

Real  Estate  25,000 

Machinery  25,000 

Supplies  25,000 

Accounts  Eeceivable  25,000 

To  Capital  Stock  100,000 

It  is  obvious  that,  at  the  time  of  the  donation, 
Donated  Stock  must  be  debited  and  something  must 
be  credited.  As  the  donation  is  out  of  a  clear  sky, 
so  to  speak,  an  account  on  the  other  side  must  be 
established  to  indicate  the  fact  that  this  surplus  has 
arisen  neither  from  the  ordinary  course  of  business 
nor  from  investment.  Some  bookkeepers  would  un- 
questioningly  credit  Surplus  in  the  ordinary  way; 
but  it  is  desirable,  if  we  are  going  to  have  our  books 
represent  the  truth,  as  they  always  should  do,  to  indi- 
cate that  this  surplus  is  of  unusual  origin.  This  can 
be  done  by  the  following  entry : 

Donated  Stock  20,000 

T^  Donated  Surplus  20,000 


GORPOEATIOIS^  AC€OUNTS  339 

This  donated  stock  may  now  be  sold,  as  we  have  seen, 
at  any  figure  which  can  be  got  for  it.  We  will  assume 
it  in  this  case  to  sell  at  $75  a  share.  Our  entry  will 
then  be  as  follows: 

Cash  15,000 

Donated  Surplus  5,000 

To  Donated  Stock  20,000 

It  is  obvious  that,  since  we  originally  credited  Do- 
nated Surplus  for  the  full  amount  of  stock  donated, 
and  then  we  failed  to  realize  the  par  value  when  it 
was  sold,  we  must  debit  that  account  for  the  differ- 
ence. It  is  better  to  enter  the  donated  stock  and  the 
donated  surplus  originally  at  the  par  value,  even 
though  we  know  that  par  value  will  not  be  received, 
than  to  enter  it  at  the  estimated  selling  price;  for  it  is 
desirable  that  so  long  as  we  have  any  donated  or 
treasury  stock  on  hand  it  shall  appear  on  the  books 
at  par  value  as  an  indication  of  the  nominal  amount 
in  the  possession  of  the  corporation.  It  may  be  worth 
while  in  such  a  case  to  open  an  account  with  Stock 
Discount  and  debit  that  account  instead  of  Donated 
Surplus  for  the  amount  of  discount,  for  if  we  wish  a 
record  on  our  books  of  the  actual  amount  of  discounts 
suffered,  we  should  keep  such  discounts  in  an  account 
by  themselves.  When  all  the  stock  is  issued.  Stock 
Discount  may  be  closed  out  into  Donated  Surplus,  re- 
ducing it  to  the  amount  actually  realized  on  the  dona- 
tions. Donated  Surplus  may  then  be  transferred  in 
turn  to  Capital  Surplus.  By  this  method  all  the  steps 
in  the  stock  issue  are  shown  clearly,  and  the  net  re- 
sult is  summarized  in  one  account. 
One  other  complication  of  the  situation  arises  when 


230  ACCOUNTING  AND  AUDITING 

stock  has  been  subscribed  for  on  the  installment  plan 
and  some  subscription  is  later  defaulted.  It  is  com- 
mon to  provide  when  installment  subscriptions  are 
received  that  if  any  sum  subscribed  for  is  unpaid 
after  a  certain  date  the  subscriber  shall  forfeit  not 
only  his  right  to  the  stock  but  even  to  the  return  of 
the  amount  already  paid  on  installments.  In  such  a 
case,  if  any  sums  have  been  paid — and  corporations 
usually  require  that  a  certain  sum  shall  be  paid  at 
the  time  of  subscription — this  amount  paid  is  a  clear 
gain  to  the  corporation.  It  is  not  a  gain,  however, 
in  the  sense  of  profits,  for  profits  ought  to  be  con- 
sidered as  only  sums  realized  from  the  operation  of 
the  business.  This  gain  is  in  a  sense  investment, 
but  it  represents  investment  for  which  the  business 
is  not  responsible  to  the  particular  person  who  made 
the  investment.  Properly,  such  gain  should  be  con- 
sidered as  surplus,  similar  to  surplus  created  by  a 
subscription  to  stock  at  more  than  par.  It  is  obvious, 
too,  that  when  any  sums  have  been  forfeited  to  the 
corporation  on  failure  to  meet  subscriptions,  these 
sums  have  actually  been  paid  on  account  of  capital 
stock  to  be  issued,  and,  therefore,  by  so  much  make 
it  possible  for  the  corporation  to  sell  stock  at  less 
than  par.  Although  the  law  requires  that  all  stock 
shall  have  been  fully  paid,  it  does  not  require  that 
stock  shall  have  been  fully  paid  by  the  purchaser; 
since  the  only  concern  of  the  stockholder  is  that  the 
corporation  shall  have  received  full  payment  from 
someone,  any  sums  paid  and  forfeited  by  one  person 
may  be  utilized  to  complete  the  payment  for  stock 
delivered  to  another.  Forfeited  payments,  then,  are 
equivalent    to  a  payment    for    that  many  dollars' 


CORPORATION  ACCOUNTS  231 

worth  of  treasury  stock  which  the  corporation  may 
dispose  of  at  its  own  terms.  A  proper  method  of 
entry  when  it  is  found  that  any  installments  have 
been  forfeited  is  to  carry  the  amount  of  forfeiture  to 
Treasury  Stock  and  indicate  that  a  certain  number 
of  shares  are  by  that  amount  fully  paid.  Suppose, 
for  instance,  the  corporation  calls  for  installments 
at  twenty-five  per  cent.,  and  after  two  installments 
have  been  paid  on  a  one-hundred  share  subscription 
finds  the  rest  defaulted.  The  corporation  has  then 
collected  on  these  shares  $5,000,  and  $5,000  remains 
to  be  paid.  The  entry  for  the  forfeiture  would  be  as 
follows : 

Treasury  Stock  5,000 

Stock  Subscribed  5,000 

To  Installment  Subscription  No.  3  2,500 

Installment  Subscription  No.  4  2,500 

Capital  Surplus  5,000 

The  Treasury  Stock  is  debited  $5,000  because  this 
amount  is  available  for  the  corporation  to  put  to  its 
own  uses  as  once  fully  paid,  and  the  gain  is  credited 
as  a  surplus.  Stock  Subscribed  is  debited  $5,000  be- 
cause, of  the  original  subscription  of  $10,000  once 
credited  to  Stock  Subscribed,  one  half  is  now  can- 
celled. The  other  half,  now  pledged  to  the  treasury, 
must  be  left  in  Stock  Subscribed  to  prevent  an  over- 
issue. The  credits  to  the  installments,  of  course, 
simply  wipe  out  the  installment  accounts  previously 
debited  and  now  cancelled.  It  would  be  possible  to 
debit  Treasury  Stock  for  the  full  $10,000  if  we  could 
properly  indicate  that  only  one  half  of  that  stock 
had  been  paid,  and  that  it  must  be  sold  for  not  less 
than  $50  a  share.    The  difficulty  would  be  in  making 


2«2  ACCOUNTING  AND  AUDITING  v 

such  an  indication  without  too  much  complication, 
and  in  avoiding  over-issue  or  under-issue.  The 
simplest  method  is  to  treat  the  $5,000  paid  and  for- 
feited as  if  it  were  full  payment  on  one  half  the  num- 
ber of  shares ;  then  the  corporation  may  do  as  it  likes 
with  that  half  and  may  call  for  subscriptions  from 
outside  for  the  other  half.  If,  indeed,  the  corpora- 
tion concludes  to  sell  the  one  hundred  forfeited 
shares  for  $50  a  share,  it  may  still  do  so,  for  it  may 
on  its  books  enter  — what  is  practically  the  fact — a 
subscription  for  fifty  shares  at  par,  with  a  bonus  of 
the  other  fifty  shares  of  treasury  stock  thrown  in. 
This  is  equivalent  to  having  a  new  subscriber  take 
up  the  subscription  of  the  old  and  pay  the  two  re- 
maining installments.  In  that  case  the  entry  will  be 
as  follows: 

Capital  Surplus  5,000 

Subscription  Installment  No.  3  2,500 

Subscription  Installment  No.  4  2,500 

To  Stock  Subscribed  5,000 

Treasury  Stock  Subscribed  5,000 

This  entry,  of  course,  reverses  the  last  entry  and 
puts  everything  back  where  it  was  before  the  for- 
feiture except  for  the  fat^t  that  the  Treasury  Stock 
is  now  pledged  (though  it  is  still  in  the  possession  of 
the  company) ;  and,  as  a  matter  of  fact,  everything 
is  as  it  was  before  the  forfeiture  except  for  the  fact 
that  the  person  who  is  to  pay  the  installments  is 
different.  On  the  actual  final  total  issue  of  stock. 
Stock  Subscribed  will  be  debited  and  Capital  Stock 
will  be  credited.  Treasury  Stock  Subscribed  will  be 
debited  and  Treasury  Stock  will  be  credited;  the  re- 


CORPORATION  ACCOUNTS  333 

suit  will  be  a  cancellation  of  all  items  but  Cash  and 
Capital  Stock. 

The  only  complication  remaining  is  that  arising 
when  shares  subscribed  for  by  installments  at  a  pre- 
mium or  at  a  discount  are  forfeited.  Here  the  entry 
for  forfeiture  must  take  into  account  the  fact  that 
surplus  or  discount  is  affected  at  the  time  of  the  for- 
feiture, for  surplus  or  discount  was  concerned  in  the 
original  subscription. 

Suppose  the  original  subscription  was  for  100 
shares  at  120,  to  be  payable  in  six  installments.  The 
original  entry  would  have  debited  six  installment 
accounts  each  for  $2,000,  would  have  credited  Stock 
Subscribed  for  $10,000,  and  Capital  Surplus,  or 
Premium  Surplus,  for  $2,000.  On  the  payment  of 
two  installments.  Cash  would  have  been  debited  for 
$4,000,  and  two  installment  accounts  would  have  been 
closed.  On  the  present  forfeiture  of  the  remainder  of 
the  right,  it  will  be  necessary  in  the  first  place  to 
debit  Stock  Subscribed  $6,000,  because  three  $2,000 
installments  of  par  value  are  no  longer  pledged,  and 
to  debit  Capital  Surplus  $2,000,  because  the  amount 
of  premium  surplus  previously  promised  is  now 
known  not  to  be  collectible.  The  calculation  of  these 
amounts  is  a  little  complicated  because  our  debit  to 
Stock  Subscribed,  which  must  cancel  the  unpaid  por- 
tion of  the  par  value,  is  based  not  on  the  payment  of 
two  installments  of  the  original  six  (leaving  four  to 
cancel),  but  on  the  payment  of  two  out  of  five  of  the 
original  six  (leaving  three  to  cancel) ;  for  one  of  the 
original  six  was  not  for  par  value,  but  for  premiiun. 
If,  on  the  other  hand,  we  had  made  our  original 
entry  in  such  form  that  the  premium  as  well  ajs  the 


234  ACCOUNTING  AND  AUDITING 

par  value  was  divided  into  installments,  we  should 
have  had  a  larger  number  of  items  on  the  books  but 
an  easier  method  of  determining  the  exact  nature  of 
the  various  installments.  In  such  a  case,  our  original 
entry  would  have  debited  six  subscription  install- 
ment accounts  each  for  $1,666.66§,  and  six  pre- 
mium installment  accounts  each  for  $333.33J.  The 
credits  would  have  been  the  same  as  before.  Then 
when  any  installment  of  $2,000  was  paid  we  should 
have  debited  Cash  and  credited  not  only  a  subscrip- 
tion installment  account  but  also  a  premium  in- 
stallment account.  Whenever  a  forfeiture  occurred, 
therefore,  the  books  w^ould  have  shown  at  once  just 
how  much  had  been  collected  on  subscription  install- 
ments, and  the  uncollected  balance  would  need  to 
be  debited  to  Stock  Subscribed  and  credited  to  the 
subscription  installment  accounts  as  no  longer  a 
pledge  of  stock  to  be  issued.  A  similar  debit  to 
Capital  Surplus  and  credit  to  premium  installment 
accounts  would  have  properly  removed  from  the 
books  the  asset  consisting  of  the  promise  to  pay 
premium.  In  ultimate  result,  therefore,  we  should 
have  got  the  same  results  as  here  by  more  entries; 
but  the  advantage  would  have  been  an  easier  de- 
termination of  just  how  much  debit  to  make  to  Stock 
Subscribed  at  the  time  of  the  forfeiture.  Under 
either  method  the  debit  to  Stock  Subscribed  wiU 
show  how  much  stock  previously  pledged  for  a  sub- 
scription is  now  free.  Next  a  debit  to  Treasury 
Stock  must  show  the  amount  of  paid-up  stock  for- 
feited to  the  treasury,  and  the  credit  to  Capital  Sur- 
plus wiU  show  the  gain  to  the  corporation  from  the 
forfeiture.    The  full  entry  for  the  forfeiture,  when 


6,000 
2,000 

4,000 

3 
4 

2,000 
2,000 

5 

6 

2,000 
2,000 

COKPOEATION  ACCOUNTS  235 

the  installments  were  not  originally  divided  between 
par  and  premium,  will  be  as  follows: 

Treasury  Stock  4,000 

Stock  Subscribed 
Capital  Surplus 

To  Capital  Surplus 

Installment  Subscription  No. 

Installment  Subscription  No. 

Installment  Subscription  No. 

Installment  Subscription  No. 

This  entry  gives  us  both  a  debit  and  a  credit  to 
Capital  Surplus.  It  would  be  possible  to  combine 
these  and  show  a  net  credit  of  $2,000;  but  in  order 
here  to  show  the  origin  of  each  they  are  given  sep- 
arately. The  debit  of  $2,000  is  to  offset  and  cancel 
expected  gain  from  the  promise  of  the  stockholder  to 
pay  $2,000  premium,  for  that  promise  is  no  longer 
binding;  but  the  credit  is  due  to  the  fact  that  he  has 
already  paid  into  the  corporation  $4,000  in  install- 
ments, which  is  now  forfeited  and  is,  consequently, 
to  be  carried  to  Capital  Surplus.  The  net  result  is 
greater  fortune  to  the  corporation  than  if  the  stock 
had  never  been  subscribed  for — provided  it  can  still 
find  a  customer  for  the  stock  at  higher  than  80 ;  for 
though  it  has  lost  this  subscriber's  promise  to  pay 
$20  premium,  it  has  collected  from  him  $40  in  cash 
without  expense  to  itself. 

If,  on  the  other  hand,  this  subscription,  now  de- 
faulted after  two  payments,  had  been  originally  for 
treasury  stock  to  be  taken  at  80  and  paid  for  by  four 
installments,  we  should  have  had  a  somewhat  differ- 
ent appearance  on  the  books.  The  original  entry 
would  have  been  a  debit  to  four  accounts  of  Treasury 
Stock  Subscription  Installments  at  $2,000  each  and 


336  ACCOUNTING  AND  AUDITING 

one  debit  to  Discount  on  Stock  (or  to  Capital  Sur- 
plus), and  a  credit  to  Treasury  Stock  Subscribed  of 
$10,000.  On  the  payment  of  two  installments,  two  of 
these  treasury  stock  subscriptions  would  have  been 
credited  and  Cash  would  have  been  debited.  On  the 
forfeiture,  it  would  be  necessary  to  debit  Treasury 
Stock  Subscribed  the  full  $10,000,  for  none  of  such 
stock  is  now  pledged,  and  the  amount  of  original 
stock  pledged  was  properly  indicated  originally 
when  this  stock  just  forfeited  was  first  put  into  the 
treasury.  At  the  same  time,  a  credit  must  be  given 
to  the  third  and  fourth  treasury  stock  subscription 
installments,  for  they  have  been  cancelled;  a  credit 
must  be  given  to  Discount  on  Stock  (or  Capital  Sur- 
plus) to  offset  the  debit  made  at  the  time  this  treas- 
ury stock  was  subscribed  for  at  80 — for  the  item 
is  at  present  cancelled  and  no  one  knows  at  what 
price  this  stock  will  ultimately  be  sold;  finally,  since 
from  this  transaction — that  is,  collecting  two  sub- 
scription installments — the  company  has  gained 
$4,000,  Capital  Surplus  must  be  credited  by  this 
amount.  These  credits  exactly  offset  the  debit  to 
Treasury  Stock  Subscribed.  In  this  case  no  debit 
needs  to  be  made  to  Treasury  Stock,  for  since  the 
treasury  stock  was  never  actually  issued — ^because 
the  installments  were  not  paid — this  account  was 
never  credited,  but  shows  that  the  stock  still  remains 
in  the  possession  of  the  treasury.  The  full  entry  fol- 
lows: 

Treasury  Stock  Subscribed  10,000 

To  Treasury  Stock  Subscription  No.  3                      2,000 

Treasury  Stock  Subscription  No.  4                     2,000 

Discount  on  Stock  2,000 

Capital  Surplus  4,000 


COEPORATION  ACCOUNTS  237 

If  no  separate  account  has  been  opened  for  Dis- 
count on  Stock,  Capital  Surplus  will  have  a  credit 
of  $6,000.  This  replaces  the  $2,000  taken  out  of  this 
account  at  the  time  the  stock  was  thought  to  have 
been  sold  at  a  discount,  and  adds  the  $4,000  gained 
on  this  forfeiture. 

The  attention  given  here  to  these  last  transac- 
tions is  out  of  proportion  to  the  importance  of  the 
subject  in  itself,  but  is  justified  by  the  opportunity 
offered  for  the  illustration  not  only  of  bookkeeping 
principles,  but  of  the  accounting  principle  which 
wisely  distinguishes  between  things  which  though 
a  good  deal  alike  in  appearance  and  in  name  are  far 
different  in  real  meaning. 


*    CHAPTER  IX 


PROPERTY  OR  EXPENSE? 


We  have  been  discussing  the  principles  of  book- 
keeping and  have  found  that  if  only  debit  and  credit 
are  properly  distinguished,  if  items  are  carried  to 
the  proper  accounts,  and  if,  in  spite  of  a  multiplicity 
of  special  columns  and  special  forms,  the  complica- 
tions do  not  lead  to  the  omission  or  duplication  of 
items,  our  books  are  bound  to  be  correct.  We  have 
been  handling  certain  accounting  problems  on  our 
way,  but  these  have  arisen  only  incidentally,  as  ma- 
terial for  bookkeeping  solutions.  We  may  now  turn 
to  accounting  pure  and  simple  and  assume  that  the 
bookkeeping  will  take  care  of  itself;  for,  as  has  been 
indicated  before,  the  task  of  the  accountant  is  to 
learn  what  is  the  real  nature  of  a  transaction — either 
before  an  entry,  so  that  the  bookkeeper  may  know 
what  facts  to  enter,  or  after  all  entries  have  been 
made,  so  that  the  manager  may  know  the  meaning 
of  the  facts  that  the  books  disclose.  If,  for  instance, 
we  make  certain  expenditure  on  our  real  estate,  it 
may  be  a  difficult  task  to  determine  whether  the 
charge  should  be  made  to  Real  Estate  or  to  Repairs. 
If  the  real  value  of  our  property  has  been  increased, 
we  ought  to  indicate  on  the  books  that  there  is  a 
greater  value  remaining  in  the  property  and  should 
therefore  debit  Real  Estate.     If  the  expenditure 

239 


240  ACCOUNTING  AND  AUDITING 

does  not  increase  the  real  value,  it  should  be  charged 
to  Repairs — that  is,  to  an  account  which  is  merely 
nominal  and  explains  the  loss  of  funds.  This  dis- 
tinction between  real  and  nominal  accounts  is  funda- 
mental and  lies  at  the  basis  of  most  problems  of  ac- 
counting. It  applies  not  only  in  making  original 
charges  for  expenditure,  but  quite  as  much  in  de- 
termining, at  the  end  of  any  earning  period  when 
we  close  our  books,  how  much  property  originally 
charged  shall  be  still  considered  a  good  asset.  To 
make  a  careful  study  of  the  problems  connected  with 
it  is  therefore  desirable  before  we  consider  complica- 
tions of  any  other  sort. 

In  the  last  paragraph  emphasis  was  laid  on  the 
reality  of  the  value.  It  may  seem  at  first  as  if  a 
value  is  a  value,  and  that  there  can  be  no  such  thing 
as  an  unreal  value.  On  general  principles  this  is 
true,  but  it  is  necessary  to  realize  that  a  thing  which 
has  value  from  one  point  of  view  has  none  from 
another,  and  that  in  accounting  we  must  recognize 
the  point  of  view  before  we  determine  w^hat  figures 
shall  be  used  in  connection  with  any  property.  If  we 
are  considering  the  value  of  property  which  we  are 
on  the  point  of  bu}dng,  we  are  concerned  only  with 
what  it  would  cost  us  to  get  that  property  some- 
where else — ^that  is,  with  the  cost  of  duplication.  So 
if  we  are  to  use  cost  of  duplication  as  the  basis  for 
valuation  on  a  balance  sheet,  in  closing  the  books  at 
the  end  of  a  year  our  sole  concern  is  to  learn  what  it 
would  cost  us  to  buy  similar  property  on  the  market. 
If,  on  the  other  hand,  we  are  not  thinking  of  buying 
property,  but  only  of  the  investment  value  to  us  of 
property  which  we  already  hold,  we  are  concerned 


PROPERTY  OR  EXPANSE  «41 

solely  with  the  income  which  it  yields.  A  house 
which  brings  an  income  of  $1,000  a  year  over  the 
taxes,  insurance,  and  repairs,  is  worth,  when  interest 
is  considered  to  be  five  per  cent.,  $20,000;  for  $20,000 
invested  elsewhere  will  produce  $1,000  a  year  at  that 
rate  of  interest.  Whether  it  would  cost  $20,000  to 
duplicate  that  house  or  not,  the  house  is  worth 
$20,000  to  the  owner  as  long  as  it  will  yield  him  an 
income  of  $1,000  a  year.  So  on  the  basis  of  earning 
capacity  we  may  have  a  very  different  valuation 
from  that  based  on  the  cost  of  duplication.  If, 
fina"'\Y,  I  have  built  a  house  for  my  own  dwelling  at 
an  original  cost  of  $20,000,  and  the  house  has  been 
kept  in  excellent  repair,  it  may  still  be  worth,  for  my 
purposes,  $20,000  and  only  $20,000;  and  this  may  be 
true  even  though  I  can  now  build  another  similar  to 
it  for  less  than  $20,000  and  even  though  I  should  have 
to  pay  more  than  $1,000  rent  for  another  house  which 
I  might  hire.  In  this  case,  it  is  not  merely  a  dwelling 
that  I  am  looking  for,  but  this  particular  dwelling, 
with  its  associations  connected  with  the  past;  the 
cost  to  me  and  the  value  to  me  are  the  same.  If  I 
abandon  my  original  purpose,  however,  and  decide 
that  another  house  will  do,  I  shall  value  it  on  a  dif- 
ferent basis.    Let  us  examine  this. 

The  situation  may  be  expressed  as  follows:  the 
house  can  now  be  duplicated  for  $15,000,  it  can  be 
rented  for  $1,250,  but  I  have  paid  $20,000.  If  another 
house  will  serve  me  just  as  well,  and  can  be  built  for 
$15,000,  my  house  is  worth  to  me  only  $15,000  and 
should  appear  on  the  balance  sheet  at  that  cost  of 
duplication;  if,  again,  I  need  only  a  house  of  that 
type  and  do  not  require  that  particular  house,  and  it 

A  &  A-16 


^42  ACCOUNTING  AND  AUDITINa 

would  cost  me  $1,250  to  hire  any  other,  this  house  is 
worth  $25,000,  because  possession  of  it  saves  $1,250 
— that  is,  its  earning  capacity  is  five  per  cent,  on 
$25,000;  but  if  only  this  house  will  serve,  my  purpose, 
its  value  is  the  cost  or  sacrifice  which  enabled  it  to 
serve  that  purpose,  namely,  $20,000.  Every  valua- 
tion must  have  regard  to  the  intent  for  which  the 
valuation  is  made.  Each  of  these  valuations,  $15,000, 
$25,000,  $20,000,  is  correct  on  the  basis  used;  but  it  is 
obvious  that  they  are  not  equally  satisfactory  for 
general  purposes.  Yet  in  actual  business  one  is 
likely  to  find  all  these  methods  defended  by  different 
persons  as  proper  for  use  in  valuations  on  balance 
sheets.  One  man  argues  for  valuation  at  cost  of 
duplication,  another  at  capitalization  of  earning 
capacity,  another  at  original  cost  or  sacrifice. 

It  has  been  common  in  railroad  accounts  to  base 
valuations  on  expected  earning  capacity  of  the  prop- 
erty purchased.  If,  for  example,  new  locomotives 
are  bought  at  an  expense  of  $100,000,  that  $100,000 
will  be  charged  to  Equipment  if  the  locomotives  are 
additions  to  equipment  and  are  expected  to  enable 
the  road  to  earn  more;  if  the  new  locomotives  take 
the  place  of  old  ones  worn  out  but  are  expected  to 
yield  to  the  road  greater  earnings  than  the  old — 
or,  what  is  the  same  thing,  reduce  operating  ex- 
penses— a  portion  of  their  cost  representing  ex- 
pected increased  earnings  may  be  charged  to  Equip- 
ment as  measuring  the  increased  earning  capacity 
of  the  road  as  a  whole,  and  the  rest  will  be  charged 
to  Maintenance  (the  practical  equivalent  of  Re- 
pairs); but  if  these  new  locomotives  are  expected 
simply  to  earn  the  same  revenue  as  the  old  loco- 


I>ROPERTY  OR  EXPENSE  M3 

motives  —  however  much  better  service  they  may 
render — the  whole  cost  will  be  charged  to  Mainte- 
nance. For  many  roads  this  last  statement  is  true 
even  if  the  cost  be  much  greater  than  the  original 
cost  of  the  locomotives  that  are  replaced.  This  is  the 
extreme  form  of  basing  valuation  on  earning 
capacity. 

Many  persons  who  complain  of  the  high  rates 
charged  by  railroads  insist  that  as  a  general  prin- 
ciple railroads  should  earn  profits  equivalent  only 
to  what  is  considered  a  fair  rate  upon  the  cost  of 
duplicating  the  property.  If  a  railroad  cost,  say, 
$50,000,000  to  build,  but  can  be  today  duplicated  for 
$40,000,000,  this  principle  would  require  that  since 
a  fair  rate  of  interest  upon  that  $40,000,000  is  all  that 
the  company  ought  to  expect  to  receive,  rates  should 
be  adjusted  so  as  to  yield  that  income.  The  advo- 
cates of  this  principle  would  on  the  balance  sheet  of 
the  railroad  show  property  equivalent  only  to  the 
cost  of  duplication.  Whether  what  they  demand  in 
the  way  of  rates  is  fair  or  not  is  hardly  an  accounting 
question;  but  it  is  undoubted  that  if  their  principle 
is  to  be  accepted — namely,  that  the  real  value  of  a 
property  is  the  cost  of  duplication — all  balance 
sheets  should  be  adjusted  to  that  basis,  and  the 
shrinkage  due  to  a  falling  value  of  property  should 
be  deducted  either  from  capital  or  from  profits. 

The  real  question  for  the  accountant  to  determine 
is  which  one  of  these  three  methods  gives  the  facts 
most  desirable  to  show  on  the  books.  A  little  thought 
suggests  that  there  is  limited  virtue  for  ac- 
counting purposes  in  representing  on  the  balance 
sheet  a  valuation  based  on  earning  capacity.    Every- 


U4:  ACCOUNTING  AND  AUDITING 

body  knows  that  when  interest  is  five  per  cent.,  for 
example,  a  property  yielding  five  dollars  a  year  is 
worth  one  hundred  dollars.  If  we  know  the  earning 
capacity  of  property,  we  do  not  need  any  bookkeep- 
ing, either  simple  or  complex,  to  show  us  the  value  of 
that  property.  To  cause  a  balance  sheet  to  show  a 
capitalization  based  on  earning  capacity,  therefore, 
is  simply  to  base  the  balance  sheet  on  the  income 
sheet — that  is,  to  fix  the  total  value  of  the  property 
at  one  hundred  times  as  much  as  the  income  divided 
by  the  number  of  per  cent,  indicating  the  current 
rate  of  interest  (income  $l,000,000-r-5  [the  current 
rate  of  interest]  =$200,000;  which  multiplied  by 
100  [to  find  100%]  =$20,000,000).  There  is  no  great 
value  in  a  balance  sheet  which  tells  little  more  (ex- 
cept some  details)  than  the  income  sheet  has  already 
suggested.  To  cause  the  balance  sheet  to  indicate 
the  cost  of  duplication,  on  the  other  hand,  is  hardly 
more  fruitful.  The  cost  of  duplicating  any  prop- 
erty is  fluctuating  continually,  and  whatever  valua- 
tion might  be  put  on  the  books  on  the  first  of  Janu- 
ary, 1911,  would  be  to  great  extent  out  of  date  by  the 
first  of  January,  1912;  and  though  a  possible  profit 
indicated  by  a  change  in  valuation  might  be  very 
high  for  that  year,  in  the  subsequent  year  a  change 
in  valuations  as  indicated  by  the  cost  of  duplication 
might  entirely  wipe  out  very  large  actual  earnings. 
It  is  not  true  that  any  propert}^  which  has  shrunk  in 
market  value  has  necessarily  involved  a  loss,  for 
unless  the  property  must  be  sold  that  nominal  de- 
preciation may  not  really  touch  it.  If  the  property 
is  just  as  good  for  serving  the  end  which  it  was  pur- 
chased to  serve,  it  is  every  whit  as  good  for  account- 


PEOPEETT  OR  EXPENSE.  M5 

ing  purposes.  In  other  words,  the  cost  of  duplica- 
tion has  nothing  whatever  to  do  with  the  value  of 
property  for  a  going  business,  and,  therefore,  may 
perfectly  well  be  disregarded  in  valuations  on  the 
books  of  any  such  business. 

It  follows,  therefore,  that  the  only  logical  basis 
for  any  valuation  as  shown  by  books  of  account  is 
the  cost  of  the  property  for  the  service  which  it  is  to 
perform.  If  property  bought  for  $50,000  can  be 
duplicated  for  $40,000,  from  one  point  of  view  it  is 
true  that  the  business  has  lost  $10,000;  but  that  is 
true  only  if  there  have  been  no  intermediate  opera- 
tions and  we  are  sure  that  the  proprietors  in  spite  of 
waiting  until  the  price  had  fallen  could  have  earned 
as  great  profits  as  they  have  earned  during  the 
period  between  the  original  purchase  and  the  time 
when  the  price  has  fallen  to  $40,000.  In  other  words, 
this  notion  of  a  loss  of  $10,000  is  based  on  a  supposi- 
tion which  is  usually  far  from  the  actual  fact;  and  of 
course  the  profits  of  business  should  be  indicated  on 
the  books  not  at  all  on  the  price  of  what  might  have 
been,  but  of  what  is  known  to  be.  Since,  moreover, 
the  figure  of  cost  could  never  be  recovered  if  once 
lost,  it  should  not  be  confused  by  artificial  valua- 
tions ;  but  since  valuations  based  on  earning  capac- 
ity and  on  cost  of  duplication  can  be  found  at  any 
time,  the  books  do  not  need  to  register  them. 

Hereafter,  in  deciding  whether  an  expenditure 
shall  be  considered  as  for  property  or  for  expense, 
we  shall  in  this  book  use  for  our  basis  neither  earn- 
ing capacity  nor  cost  of  duplication,  but  the  actual 
legitimate  cost  or  sacrifice  in  securing  the  property 
adequate  for  the  desired  service;    for,  as  we  have 


246  ACCOUNTING  AND  AUDITING 

seen,  that  is  the  only  scientific  method.  We  consider 
property  to  be  whatever  will  render  future  economic 
service — even  though  that  service  be  not  productive 
of  new  revenue, — such  as  new  locomotives  that  will 
merely  run  more  reliably.  One  should  realize,  how- 
ever, that  by  cost,  or  sacrifice,  is  meant  only  the  cost 
or  sacrifice  not  yet  compensated  for.  If,  for  instance, 
machinery  has  been  in  part  worn  out  by  use,  con- 
verting itself,  so  to  speak,  into  manufactured  goods, 
the  original  cost  of  the  machinery  has  been  in 
part  compensated  for  in  its  product,  and  only  the 
cost  of  the  portion  yet  unconsumed  should  now  be 
considered  as  an  asset.  Depreciation  must  always  be 
considered  before  the  figure  of  cost  or  sacrifice  to 
stand  on  the  books  as  an  asset  is  determined. 

An  interesting  problem  arises  if  at  a  time  of  re- 
placement of  worn-out  property  the  new  property  is 
acquired  at  a  different  price  from  the  old.  If  the 
extra  cost  is  accompanied  by  an  extra  efficiency, 
coupled  with  k  corresponding  increased  earning 
capacity,  unquestionably  the  new  additional  cost 
may  be  charged  as  a  real  asset,  for  from  every  point 
of  view — ^that  of  valuation  based  on  earning  capac- 
ity, on  cost  of  duplication,  on  original  cost — the  value 
of  the  property  is  greater.  If,  again,  though  the 
earning  capacity  is  not  greater,  efficiency  is  in- 
creased, from  the  point  of  view  of  valuation  based 
on  cost,  the  increased  expenditure  should  be  con- 
sidered an  asset — for  though  it  will  not  earn  more,  it 
will  actually  perform  additional  service  to  the  com- 
munity. 

When,  on  the  contrary,  such  property  is  replaced 
at  a  lower  cost  than  the  original,  a  rather  nice  new 


PROPERTY  OR  EXPENSE  247 

problem  in  accounting  is  raised.  This  difference  be- 
tween the  two  costs  is  a  gain  to  the  company,  for  the 
same  efficiency  and  the  same  earning  power  are  re- 
placed at  a  lower  cost.  It  would  not  be  wise  account- 
ing, on  the  other  hand,  to  consider  this  as  profit  for 
the  year  in  which  the  replacement  took  place.  What 
has  really  happened  is  that  the  operating  facilities 
of  the  company  have  been  kept  intact  by  this  re- 
placement purchase,  and  that  still  a  certain  surplus 
of  product  (for  the  replacement  should  be  provided 
for  out  of  product,  of  course)  proves  to  remain  after 
the  expenditure  of  the  amount  necessary  to  keep  the 
capital  in  good  working  order.  This  surplus  has  had 
its  origin  in  all  the  years  in  which  the  old  capital 
was  in  use,  even  though  it  may  chance  that  the  exact 
replacement  and  therefore  the  gain  on  replacement 
occur  in  only  one  of  the  years.  In  result,  then,  this 
gain  is  nothing  but  capital  now  set  free  by  the 
changes  in  conditions  in  the  commimity.  It  has  not 
been  earned  by  the  company  through  its  operations; 
it  has  not  been  contributed  by  stockholders;  it  is 
benefit  derived,  probably,  from  the  progress  of  the 
arts.  The  assets  account  should  show  what  the 
equipment  now  on  hand  has  cost — the  sacrifice  that 
the  company  has  made  for  this  property;  and  as  the 
cost  of  the  original  property  has  been  returned, 
through  product,  and  is  more  than  enough  to  replace 
the  worn-out  property  (assuming,  of  course,  that  the 
business  is  successful),  the  original  cost  is  no  longer 
in  the  equipment  and  therefore  the  valuation  should 
be  reduced  on  the  books. 

Let  us  glance  at  the  entries.    As  the  old  equip- 
ment (costing,  we  will  say,  $10,000)  wore  out,  it  pro- 


248  ACCOUNTING  AND  AUDITING 

duced  revenue,  and  cash  (or  its  equivalent)  became 
debited  to  the  amount  of  $10,000  above  other  ex- 
penses and  normal  profits.  Since,  when  this  equip- 
ment needed  to  be  replaced,  only  $8,000  was  needed, 
$2,000  remains  in  cash.  Since  the  original  $10,000 
valuation  must  be  reduced  to  $8,000,  for  only  that 
value  now  remains  in  the  form  of  equipment,  this 
$2,000  remaining  in  cash  takes  the  place  of  the  $2,000 
displaced  from  equipment.  The  entry  at  the  time  of 
replacement,  then,  is  as  follows: 

Maintenance  8,000 

Profit  and  Loss  2,000 

To  Cash  8,000 

Equipment  2,000 

This  entry  accomplishes  three  purposes.  It  reduces 
equipment  to  the  cost  of  what  is  now  on  hand.  It 
shows  the  actual  expenditure  for  maintenance.  It 
shows  that  the  product  of  the  business  is  responsible 
to  do  more  than  merely  replace  the  efficiency  of  the 
equipment;  for  by  debiting  Profit  and  Loss  $2,000  it 
declares  that  no  profit  can  be  counted  imtil  $2,000 
in  addition  to  maintenance  has  been  deducted  from 
product  as  an  offset  to  property  consumed  and  not 
replaced  in  value.  The  actual  consumption  of  value 
has  been  $10,000.  Though  the  worn-out  equipment 
has  been  replaced  in  efficiency,  if  the  books  fail  to 
record  that  it  has  not  been  replaced  also  in  value  the 
gain  from  the  lower  price  will  be  taken  up  as  profits 
in  the  year  of  replacement,  and,  as  we  have  seen,  it 
is  not  a  gain  of  that  year.  The  gain  from  the  lower 
price  of  the  new  equipment  comes  from  the  setting 
free  of  assets — which  were  previously  $10,000  in 


PROPERTY  OR  EXPENSE  249 

equipment,  but  are  now  only  $8,000  in  equipment 
with  cash  set  free  (from  earnings)  of  $2,000;  and 
this  $2,000  can  be  either  returned  to  stockholders  or 
invested  to  earn  more  profits. 

Before  we  attempt  to  work  out  new  problems,  let 
us  summarize  the  situation.  Let  us  assume  that  our 
ledger  accounts  are  so  named  as  to  indicate  sufficiently 
which  of  them  are  intended  to  represent  property 
and  which  mere  forces  involving  profit  or  loss.  Our 
property  accounts  we  will  assume  to  be  Real  Es- 
tate, Plant  and  Machinery,  Bills  Receivable,  etc., 
and  our  nominal  accounts  to  be  Expense,  Rent, 
Taxes,  Insurance,  etc.  We  are  likely  at  any  time  to 
have  certain  expenditures  for  repairs  of  machinery 
and  plant.  If  an  expenditure  of  this  nature  in- 
creases the  value  of  the  property  over  that  appear- 
ing on  the  books,  it  should  be  debited  to  the  real  ac- 
count. Plant  and  Machinery;  if  it  merely  replaces  a 
value  worn  out,  such  as  substituting  a  new  part  for 
one  broken,  the  charge  should  be  made  not  to  Plant 
and  Machinery,  but  to  some  nominal  account  which 
will  indicate  on  the  books  at  the  end  of  the  period  a 
loss  or  cost  of  conducting  the  business.  In  every 
case  of  this  sort,  then,  it  is  desirable  to  determine  be- 
fore the  entry  is  made  just  what  is  the  ultimate 
result  of  the  expenditure.  A  charge  to  a  real  ac- 
count implies  that  the  property  is  expected  to  re- 
main at  the  end  of  the  earning  period  and  to  be 
counted  as  a  good  asset;  a  charge  to  a  nominal  ac- 
count implies  that  nothing  of  this  expenditure  is  to 
be  counted  as  an  asset  at  the  end  of  the  period.  Yet 
in  spite  of  the  fact  that  it  is  not  always  easy  to  know 
whether  an  expenditure  is  of  one  sort  or  the  other, 


250  ACCOUNTIN'G  AND  AUDITING 

the  line  must  be  drawn  as  exactly  as  the  nature  of 
the  case  allows.  If  carelessness  occurs,  one  may  find 
that  assets  have  disappeared  without  any  record  on 
the  books.  We  shall  find  many  cases  in  which  the 
real  decision  will  depend  upon  a  consideration  not  at 
first  obvious;  but  always  the  principle  underlying 
can  be  found  if  one  analyzes  the  case  deeply  enough. 
As  we  saw  in  Chapter  VI.,  however,  property  ac- 
counts usually  have  some  profit  and  loss  relations — 
depreciation,  for  example, — and  nominal  accounts 
are  likely  to  include  accrued  or  prepaid  items.  Al- 
lowances are  therefore  inevitable.  The  necessary 
thing,  then,  is  not  so  much  that  the  line  between  prop- 
erty and  expense  be  drawn  exactly  at  the  time  an 
entry  is  made,  as  that  it  shall  be  drawn  correctly  at 
the  time  the  books  are  closed ;  but  a  correct  drawing 
of  the  line  during  the  year  makes  easier  a  correct 
drawing  of  it  at  the  close. 

The  distinction  between  property  and  expense, 
moreover,  is  not  more  important  than  the  distinction 
between  property  and  revenue;  for  to  consider  as 
clear  profit  a  sum  received  from  the  sale  of  property 
is  as  great  an  error  as  to  conceive  to  be  property  what 
was  really  only  expense.  One  must  distinguish  as 
carefully  between  real  and  nominal  accounts  in  mak*^ 
ing  credits  as  in  making  debits. 

Let  us  take  an  extreme  case.  Everyone  knows 
that  certain  bonds  sell  at  more  than  par  value — that, 
for  instance,  a  four  per  cent,  bond  of  a  good  railroad 
which  promises  to  pay  $1,000  twenty  years  from  now 
is  likely  to  sell  at  considerably  more  than  $1,000 — 
perhaps  for  $1,046.25.  The  reason  for  this  premium 
is  that  investors  believe  so  thoroughly  in  the  security 


PEOPEETY  OE  EXPENSE  251 

of  the  investment  that  they  consider  that  they  are 
taking  practically  no  risk  and  can  afford  to  lend 
their  money  at  a  low  rate  of  interest — so  low,  indeed, 
that  the  four  per  cent,  paid  by  the  bond  is  more  than 
they  insist  upon  getting.  They  bid  against  each 
other  and^ffer  for  the  bond,  then,  more  than  $1,000, 
because  the  extra  interest  w^hich  they  will  be  re- 
ceiving as  long  as  the  bond  runs  is  worth  a  premium. 
Though  they  pay  $1,046.25,  however,  they  will  re- 
ceive when  the  bond  matures  only  $1,000,  and  out  of 
the  interest  pajTuent  received  every  half  year  they 
must  set  aside  a  certain  sum  to  make  good  that 
shrinkage  of  $46.25  which  they  will  suffer  at  the  ma- 
turity of  the  bond;  that  is  to  say,  they  must  realize 
that  the  reason  they  are  paying  cash  premium  out- 
right when  they  buy  the  bond  at  $1,046.25  is  because 
they  expect  a  semi-annual  payment  of  more  than  the 
required  rate  of  interest  while  the  bond  lasts,  and 
this  extra  sum  of  semi-annual  payment  is  not  in- 
terest upon  their  investment  but  is  simply  part  re- 
payment of  the  $46.25  premium  which  they  paid. 
Suppose  an  estate  is  entirely  invested  in  such  bonds, 
and  the  trustee,  who  is  charged  by  a  will  to  ad- 
minister the  property  so  that  the  widow  of  the  tes- 
tator shall  receive  the  income  of  the  estate  and  the 
sons  shall  inherit  the  body  or  ^^ corpus"  of  the  estate 
at  the  death  of  the  widow,  does  not  realize  that  a 
part  of  the  semi-annual  interest  payment  includes  a 
partial  return  of  the  $46.25  premium  on  each  bond. 
In  this  case  he  will  turn  over  semi-annually  to  the 
widow  $20  for  every  installment  of  interest  on  each 
bond.  When  the  bonds  mature,  if  the  widow  is  still 
living,  but  $1,000  will  remain  for  each  bond — though 


U2  ACCOLTNTING  AISTD  AUDITINa 

the  estate  originally  included  $1,046.25  for  each. 
Suppose,  now,  the  trustee  invests  this  $1,000  return- 
ed principal  in  other  bonds  for  which  possibly  he 
pays  $1,250  because  the  rate  of  interest  offered  is 
high.  At  the  maturity  of  these  last  bonds,  again,  he 
collects  only  $1,000  for  each,  and  in  the  meantime 
has  paid  the  widow  the  full  amount  of  interest  re- 
ceived on  the  bonds  purchased  at  $1,250.  Once  more 
he  invests  the  principal  in  other  bonds,  perhaps  at 
133^.  It  is  obvious  that  if  this  process  continues 
very  long,  though  on  the  face  of  it  the  trustee  has 
apparently  been  paying  to  the  widow  only  the  in- 
come on  the  bonds — namely,  the  interest  which  the 
bonds  pay-— he  has  in  reality  been  paying  her  a  part 
of  the  principal,  and  on  her  death  the  amount  of 
principal  remaining  in  the  fund  will  have  shrunk 
considerably;  for  each  time  the  par  value  of  a  bond 
is  paid  and  he  purchases  new  bonds  at  a  premium  he 
gets  a  smaller  face  value  of  bonds  than  he  had  be- 
fore, so  that  whereas  the  original  investment  maj 
have  been  $104,625,  it  will  now  be  only  $60,000' 
He  fails  to  live  up  to  the  terms  of  the  will  because  he 
does  not  recognize  the  difference  between  capital 
and  revenue,  between  real  accounts  and  nominal  ac- 
counts. He  should  have  known  that  though  a  part  of 
every  semi-annual  interest  payment  was  income  or 
interest  on  the  capital  of  the  estate,  another  part  was 
simply  the  repayment  of  principal,  which  ought  to 
be  kept  intact  and  reinvested  in  order  that  the  re- 
mainder-men or  inheritors  of  the  permanent  estate 
shall  not  suffer  loss  through  his  neglect  of  account- 
ing principles. 

This  sort  of    case    is    of    frequent  occurrence. 


PROPERTY  OR  EXPENSfe  253 

though  the  names  by  which  the  property  is  called 
may  differ  widely.  If  we  have  an  impression,  for  in- 
stance, that  we  are  keeping  up  our  machinery  by  re- 
pairs and  replacements  and  each  year  charge  to 
Maintenance  what  seems  to  us  a  reasonable  figure 
for  such  repairs  and  replacements,  we  may  find  sud- 
denly that  machinery  standing  on  our  books  at  a 
valuation  of  $50,000  is  worth  only  $10,000.  This 
error  in  judgment  may  have  arisen  not  at  all  from  a 
failure  to  spend  enough  in  repairs  and  replacements, 
but  from  a  neglect  to  realize  that  machinery  may 
sometimes  become  worthless  though  it  is  quite  as 
efficient  in  production  as  it  was  the  day  it  was  new. 
Many  times  in  the  last  hundred  years  machinery  as 
good  as  could  be  made  has  been  kept  equally  good  so 
far  as  its  own  production  is  concerned,  and  yet  has 
become  worthless  because  other  machinery  has  been 
invented  and  put  upon  the  market  to  do  either  the 
same  work  at  a  cost  so  low  that  the  old  machinery 
could  not  compete  with  it  in  price,  or  to  do  work  so 
far  superior  that  the  old  machinery  could  not  com- 
pete with  it  in  quality  at  the  old  price.  Here,  then, 
was  no  failure  of  calculation  in  keeping  up  the  prop- 
erty; there  was  only  failure  to  recognize  the  force  of 
change  in  business  operations.  Allowance  should 
always  be  made,  in  any  business  using  machinery, 
for  possible  supplanting  of  property  before  it  has 
lost  its  original  efficiency — for  what  is  commonly 
called  '* obsolescence,"  or  growing  old.  In  some  lines 
of  business  the  average  period  of  obsolescence  is  per- 
haps five  years,  even  though  the  machinery  itself 
might  last  for  twenty  years.  Accounting  is  good 
only  when  it  represents  on  the  books  all  the  facts: 


254  ACCOtJNTiNG  AND  AUDITING^ 

and,  therefore,  the  books  should  show  that  a  part  of 
each  year's  product  should  be  devoted  to  establish- 
ing and  keeping  up  a  fund  big  enough  to  replace 
obsolete  machinery  as  often  as  on  the  average  it  is 
likely  to  require  such  replacement.  If  this  is  not 
done,  the  books  are  representing  profits  as  far 
greater  than  they  really  are. 

Another  illustration  of  the  same  thing  applies  in 
the  use  of  what  are  commonly  called  ^^  wasting  as- 
sets." It  may  be  known,  for  instance,  that  a  certain 
quarry  has  in  it  marble  enough  to  produce  50,000 
tons  a  year  for  twenty  j^ears.  We  may  pay  $20,00p 
for  the  right  to  get  out  marble  from  that  quarry.  If 
we  figure  profits  by  simply  subtracting  from  sales 
the  cost  of  getting  out,  dressing,  and  selling  the 
marble,  we  are  misrepresenting  our  profits;  for  at 
the  expiration  of  the  twenty  years  we  shall  have  no 
asset  left  in  the  form  of  quarry  right,  and  the  $20,000 
will  have  disappeared.  Proper  accounting  would  in- 
dicate how  much  of  each  year's  product  should  be 
set  aside  to  keep  intact  the  original  investment.  This 
need  not  necessarily  be  set  aside  in  cash  or  invested, 
but  may  be  used  possibly  in  the  development  of  the 
business  in  some  other  line,  as,  for  instance,  in  the 
gradual  purchase  of  other  quarry  rights  to  take  the 
place  of  that  exhausted.  It  is  inevitable,  however, 
that  if  the  books  are  kept  so  as  to  neglect  the  gradual 
exhaustion  of  this  quarry  right  and  to  maintain  it 
continually  at  a  valuation  of  $20,000,  on  the  ex- 
haustion of  the  rock  that  $20,000  asset  will  seem  to 
have  shrunk  in  a  moment  to  nothing,  and  there  will 
be  a  deficit  instead  of  a  profit  as  a  result  of  the  last 


PEOPERTY  OR  EXPENSE  255 

period  of  operation — unless,  indeed,  the  profits  are 
extraordinary  and  could  easily  swallow  up  such  a 
shrinkage. 

These  cases  are  fairly  simple  when  we  once 
recognize  the  fact  of  shrinking  assets.  The  only 
complication  is  in  the  figuring  to  determine  just 
what  allowance  shall  be  made  each  year,  and  that 
computation  is  in  most  cases  a  mere  matter  of  arith- 
metic applied  to  a  judgment  concerning  the  probable 
duration  of  the  property.  In  the  case  of  a  bond  the 
valuation  is  capable  of  exact  computation  as  soon  as 
the  basis  of  interest  is  determined.  A  case  involving 
the  same  principle  where  there  may  be  some  differ- 
ence of  opinion  as  to  the  method  of  calculation  may 
be  illustrated  by  agreements  involving  a  maximum 
and  a  minimum  sale.  Suppose  we  are  in  the  publish- 
ing business  and  have  made  plates  for  a  book  under 
an  agreement  with  certain  booksellers  that  we  will 
supply  them  with  a  thousand  copies  a  year  for  five 
years,  and  that  they  will  take  the  five  thousand 
copies  at  any  time  in  five  years  provided  not  over 
three  thousand  copies  shall  be  delivered  in  any  one 
year.  Under  this  agreement  we  have  the  option  of 
supplying  from  one  to  three  thousand  copies  in  any 
one  year,  but  we  are  not  obliged  to  furnish  more  than 
one  thousand,  and  we  know  that  the  maximum  sale 
at  least  under  this  contract  will  be  five  thousand 
copies.  Let  it  be  assumed,  also,  that  we  have  no 
faith  to  believe  that  more  than  five  thousand  copies 
will  ever  be  sold.  This  is  not,  of  course,  a  common 
agreement,  but  it  illustrates  a  principle  which  is 
common  in  many  relations.    Let  us  suppose  that  we 


m^  ACCOUNTING  AND  AUDITING 

supply  the  publishers  two  thousand  copies  in  the 
first  year,  and  that  the  plates  for  the  book — which, 
of  course,  are  useless  for  any  other  purpose  than 
printing  this  particular  book — ^have  cost  us  $500. 
What  shall  we  consider  a  proper  allowance  to  make 
for  depreciation  of  those  plates  during  this  year"?  Is 
it  one-fifth  because  one-fifth  of  the  five  years  of  the 
contract  has  expired,  or  is  it  two-fifths  because  two- 
fifths  of  the  total  expected  sales  have  already  been 
made?  On  one  basis,  of  course,  the  plates  have 
served  one-fifth  of  their  usefulness — if  we  assume 
that  they  will  last  for  the  printing  of  as  many  as  five 
thousand  copies,  which  is,  of  course,  presumable.  On 
the  other  basis,  since  the  total  amount  of  the  con- 
tract is  five  thousand  copies,  and  two  thousand  have 
been  produced  and  sold,  the  plates  have  served  two- 
fifths  of  their  usefulness.  Yet  a  decision  of  this  mat- 
ter involves  a  difference  of  $100  profit  for  the  year — 
that  is,  the  difference  between  one-fifth,  or  $100,  and 
two-fifths,  or  $200.  In  a  case  of  this  sort  something 
else  than  a  consideration  of  mere  lapse  of  time  is 
necessary  to  enable  us  to  determine  what  proportion 
of  the  value  should  be  written  off  in  any  period.  In 
this  case,  it  is  true  that  the  plates  have  not  appre- 
ciably lost  in  productiveness,  and  can  produce  many 
more  than  the  five  thousand  copies;  but  since  their 
actual  effectiveness  is  to  be  only  five  thousand 
copies,  and  two  thousand  have  been  produced,  we  are 
concerned  not  with  how  much  potential  value  is  left 
in  them  but  with  how  much  actual  value  has  been 
exhausted.  Here  the  exhaustion  of  value  is  two 
thousand,  and  we  must  reduce  the  original  value  of 


PEOPERTY  OH  EXPENSE  25'J 

the  plates  by  two-fifths,  or  by  $200 — though  theo- 
retically only  one-fifth  of  the  time  of  the  contract 
has  elapsed  and  though  the  plates  might  potentially 
serve  for  printing  twenty  thousand  copies. 

Still  one  sort  of  case  remains — different  from  the 
others,  however,  only  in  the  magnitude  of  the 
shrinkage.  Let  us  suppose  that  it  is  learned  that  a 
railroad  contemplates  changing  its  traffic  arrange- 
ments in  such  fashion  that  a  certain  town  heretofore 
of  slight  consequence  is  to  be  made  a  great  railroad 
center.  We  seek  to  make  a  profit  out  of  the  change 
and  build  a  large  hotel  at  heavy  expense  in  order  to 
cater  to  the  traveling  public  which  must  use  this 
junction.  At  about  the  time  the  hotel  is  completed 
it  is  found  that  on  account  of  legal  complications  and 
competition  with  water  transportation  the  railroad 
is  obliged  to  abandon  its  plans  of  increasing  traffic 
at  this  point,  and  our  hotel  is  a  white  elephant.  What 
shall  we  do  with  the  value  of  the  property  as  stand- 
ing on  our  books'?  Though  the  hotel  actually  cost 
what  we  have  charged  to  Real  Estate,  it  is  not  from 
any  point  of  view  worth  anything  like  that  sum.  In- 
deed, it  is  conceivable  that  it  will  be  practically 
worthless  if  there  is  no  demand  for  such  a  building 
in  that  locality.  Even  our  principle  of  basing  valua- 
tion on  cost,  as  expounded  in  the  first  part  of  this 
chapter,  would  put  this  valuation  down;  for  the  cost 
there  used  was  the  cost  of  getting  the  desired 
efficiency,  and  here  the  desired  efficiency  is  not  pro- 
duced and  the  expenditure  was  therefore  wasted.  It 
would  not  be  necessary  in  such  a  case  to  make  anv 
entries  on  the  books  until  it  became  time  to  close  the 


258  ACCOUNTING  AND  AUDITING 

accounts  at  the  end  of  the  year;  for  the  debit  to  this 
account,  originally  made  with  the  thought  that  the 
account  represented  an  asset,  would  simply  turn  out 
to  be  a  debit  to  an  explanation  account — merely  ex- 
plaining the  loss  of  this  value.  In  closing  our  books 
at  the  end  of  the  year,  therefore,  we  should  carry 
this  debit  not  into  the  resource  column  of  a  six- 
column  statement  (as  described  in  Chapter  VI.), 
which  is  equivalent  to  considering  it  a  good  asset, 
but  into  the  loss  column  of  such  a  statement,  which 
is  equivalent  to  considering  it  merely  an  explanation 
for  the  disappearance  of  property.  It  is  noteworthy 
that  the  bookkeeping  will  be  absolutely  the  same  in 
both  cases — ^that  is,  whether  the  property  be  con- 
ceived to  remain  or  to  be  exhausted:  only  in  the 
treatment  of  the  account  at  the  end  of  the  year,  in 
drawing  conclusions  from  the  books,  shall  we  need 
to  know  whether  the  property  really  exists  or  has 
disappeared.  Many  accounts  are  of  this  sort.  The 
commonest,  of  course,  is  that  for  bad  debts.  If  we 
have  sold  goods  to  one  of  our  regular  customers,  as 
long  as  the  account  remains  on  the  books  we  are  in 
the  habit  of  counting  it  as  an  asset;  but  if  the  cus- 
tomer suddenly  goes  into  bankruptcy,  with  the 
ability  to  pay  nothing  whatever,  the  account  may 
still  remain  on  our  books,  but  we  must  recognize  that 
it  is  nominal,  explaining  a  loss  instead  of  represent- 
ing an  asset. 

In  any  case,  when  we  are  handling  accounts  it  is 
desirable  that  we  shall  use  the  most  conservative 
judgment  as  to  valuations,  for  only  so  can  we  be  sure 
that  we  are  not  considering  as  still  on  hand  property 
which  was  long  ago  consumed.    The  basis  of  sueH  a 


PROPERTY  OR  EXPENSE  259 

valuation  will  be  determined  by  the  particular  case 
in  hand,  and  no  general  principle  can  be  laid  down 
except  that  the  valuation  should  always  be  made  as 
accurate  as  possible  and  in  cases  of  genuine  doubt 
the  lowest  probable.  With  regard  to  merchandise, 
for  instance,  the  valuation  should  be  put  at  cost  price 
if  we  are  judging  the  business  with  the  expectation 
of  selling  the  goods  in  the  ordinary  run  of  trade  and 
no  marked  fall  in  value  has  occurred  since  they  were 
purchased.  If,  on  the  other  hand,  we  are  considering 
a  winding-up  of  affairs,  so  that  the  merchandise 
must  be  sold  for  a  lump  sum,  either  at  private  sale  or 
by  auction,  we  are  sure  that  it  will  not  bring  any- 
thing like  its  proper  price,  and  the  valuation  should 
be,  therefore,  a  great  deal  less  than  cost. 

Whenever  an  item  is  presumed  to  be  an  asset 
and,  therefore,  remaining  on  hand  at  the  end  of  the 
earning  period  (usually  a  year),  so  that  it  is  debited 
to  a  real  account,  it  is  commonly  said  to  be  ^^  charged 
to  capital";  when,  on  the  other  hand,  it  is  presumed 
to  be  consumed  during  the  year  and  is  debited  to  a 
nominal  account,  it  is  commonly  said  to  be  **  charged 
to  revenue."  In  the  terms  of  the  six-column  state- 
ment discussed  in  Chapter  VI.,  charging  to  capital  is 
debiting  an  item  to  an  account  so  that  the  amount 
will  appear  among  the  resources  in  the  six-column 
statement;  and  charging  to  revenue  is  debiting  an 
amount  so  that  it  will  appear  among  the  losses  on 
that  statement.  To  '^charge  to  revenue"  is  really  an 
unfortunate  expression,  for  revenues  are  always 
credits;  the  expression  means  that  the  item  will  be 
subtracted  from  earnings  at  the  end  of  the  year.  A 
better  expression  is  '^charging  against  revenue." 


260  ACCOUNTING  AND  AUDITING 

As  was  stated  in  Chapter  VI.,  most  business 
houses,  in  drawing  up  their  conclusions  at  the  end 
of  the  year  or  in  making  reports  to  commercial 
agencies  and  to  stockholders,  give  the  facts  as  shown 
in  a  six-column  statement,  but  in  a  somewhat  dif- 
ferent form.  The  six-column  statement  is  usually 
supplanted  by  two  statements,  one  of  which,  the  bal- 
ance sheet,  contains  on  one  side  a  list  of  all  assets 
and  on  the  other  a  list  of  all  liabilities,  and  the  other, 
the  income  sheet,  contains  a  condensed  list  of  the 
items  in  the  last  pair  of  columns  on  the  six-column 
statement,  viz.,  those  for  loss  and  gain.  It  will  be 
seen  that  the  balance  sheet  shows  the  condition  of 
the  business  at  the  end  of  the  year,  after  all  allow- 
ances for  depreciation  and  accrued  items  have  been 
made.  The  income  sheet,  on  the  other  hand,  repre- 
sents not  at  all  the  condition  at  the  end  of  the  year, 
but  simply  the  summary  of  all  transactions  affecting 
profit  and  loss  during  the  year.  The  balance  sheet, 
in  other  words,  represents  the  facts  at  a  definite 
moment  of  time  and  can  bear  a  definite  date ;  but  the 
income  sheet  represents  the  nominal  accounts  over 
a  period  of  time,  usually  one  year.  As  a  good  illustra- 
tion of  these  two  sheets  extracts  from  the  annual  re- 
ports of  the  United  States  Steel  Corporation  are  ap- 
pended. 


PEOPERTY  OR  EXPENSE  361 

BALANCE  SHEET 

ASSETS 

Property  (real  estate,  plant,  etc.) $1,500,092,134.63 

Mining  royalties,  etc.,  paid  in  advance 6,763,191.22 

Investments  (outside  real  estate,  etc.) 2,353,109.56 

Special  funds  21,738,953.06 

Current  assets  (inventories,  cash  claims,  etc.) 291,018,166.95 

$1,821,965,555.42 

LIABILITIES 

Capital  stock $  869,202,602.50 

Funded  and  mortgage  debt 609,147,904.87 

Current  liabilities   61,144,725.55 

Special  funds  131,115,794.75 

Surplus*    151,354,527.75 

$1,821,965,555.42 


INCOME  SHEET 

Gross  receipts  from  production $646,382,251.29 

Producing  costs,  including  maintenance...   $483,417,842,21 

Administrative  and  selling  costs 19,082,226.90  502,500,069.11 

Net  receipts  from  operation $143,882,182.18 

Other  income 6,817,998.87 

Gross  income $150,700,181.05 

Taxes $     8,704,193.39 

Interest    31,504,471.58  40,208,664.97 

Net  income  from  operations $110,491,516.08 

Less  profits  between  departments,  not  yet  realized  by  the 

combined  business 2,617,395.54 

$107,874,120.54 
Appropriations  for  sinking  funds,  extraordinary  deprecia- 
tion allowance,  etc 29,348,870.58 

Available  for  dividends $  78,525,249.96 

Dividends   45,551,777.00 

Surplus  for  year $  32,973,472.96 

*  This  includes  the  surplus  for  the  year,   brought  from  the  income 
sheet  below. 


CHAPTER  X 


DEPKECIATION 


We  saw  in  the  last  chapter  that  it  is  necessary 
whenever  one  is  drawing  conclusions  from  books  of 
account  to  make  allowances  for  changes  in  value  of 
many  kinds  of  property.  Indeed,  there  is  practically 
nothing  in  busiaess  which  remains  for  long  quite  the 
same  in  value.  Let  us  examine  several  kinds  of  prop- 
erty subject  to  different  laws  of  change. 

The  most  common  property  on  which  deprecia- 
tion must  be  figured  is  merchandise.  If  a  stock  of 
goods  is  turned  over  rapidly  and  is  of  a  standard 
variety,  very  little  allowance  need  be  made.  A  coal 
dealer,  for  instance,  is  likely  very  seldom  to  make  al- 
lowance for  depreciation  unless  a  fire  gets  into  his 
bins.  Even  he,  however,  must  see  to  it  that  no  short- 
age results  from  careless  weighing  and  from  theft. 
Since  coal  is  usually  bought  by  the  gross  ton  of  2,240 
lbs.,  and  is  sold  by  net  tons  of  2,000  lbs.,  a  shortage  is 
little  likely  to  occur.  A  wine  dealer,  on  the  other 
hand,  is  likely  to  suffer  considerable  loss  from  break- 
age, and  therefore,  though  in  general  it  is  true  that 
his  stock  increases  in  value  with  age,  it  may  never- 
theless be  true  that  an  amount  of  money  invested  in 
wine  may  suffer  shrinkage  in  the  course  of  time  if 
there  is  careless  handling.  For  ordinary  stocks  of 
goods,  however,  many  elements  of  depreciation,  but 

263 


264  ACCOUNTING  AND  AUDITING 

few  of  appreciation,  are  likely  to  be  at  work.  One  is 
the  common  change  of  fashion,  or  custom,  which  ren- 
ders goods  once  of  high  value  practically  worthless. 
The  effect  of  this  varies  in  force  not  only  from  busi- 
ness to  business,  but  even  from  line  to  line  in  the 
same  business.  In  a  dry  goods  store,  for  instance, 
cotton  sheeting  is  likely  to  be  fairly  steady  from  year 
to  year  not  only  in  price,  but  also  in  demand.  Its 
value  decreases  only  slowly,  moreover,  with  de- 
terioration. Expensive  figured  silks,  on  the  other 
hand,  are  likely  to  vary  in  value  not  only  because  of 
changing  prices  and  of  varying  demand,  but  because 
of  deterioration  with  age.  In  valuing  stocks  of 
goods,  therefore,  it  is  essential  that  one  shall  con- 
sider many  factors.  In  other  words,  a  stock  cannot 
necessarily  be  valued  at  all  on  the  basis  of  purchase 
price,  nor  can  any  normal  percentage  of  depreciation 
be  applied  generally  for  any  business  selling  many 
varieties.  The  only  effectual  valuation  is  to  examine 
the  goods  in  detail  and  see  what  is  the  probable  de- 
preciation on  each  sort.  In  the  book  business,  again, 
there  is  still  another  element  of  depreciation  in  the 
privilege  which  most  customers  or  intending  cus- 
tomers or  pretending  customers  have  of  examining 
books  offered  for  sale.  The  loss  from  the  difference 
in  price  between  fresh  and  shop-worn  goods  is  likely 
to  be  considerable.  This  applies  in  many  other  lines 
of  business. 

Real  estate  is  subject  to  changes  in  value  both 
upward  and  downward;  but  the  upward  movement 
is  sure  to  be  confined  to  the  value  of  the  land  itself 
or  to  leases,  whereas  the  buildings  are  sure  of  a 
downward  tendency  even  when  repairs  are  made  with 


DEPEECIATION  265 

frequency.  Certain  parts  of  buildings  are  so  inac- 
cessible that  extensive  structural  repairs  would  re- 
quire an  expense  even  practically  prohibitive.  The 
changes  in  factory,  store,  and  office  conditions,  more- 
over, require  different  construction  as  the  years  go 
on  and  make  it  often  cheaper  to  demolish  and  re- 
build than  to  repair  or  alter.  The  rates  of  deprecia- 
tion on  buildings  are  various,  for  the  use -to  which 
a  building  is  put  has  a  great  influence  upon  its  dur- 
ability. A  stone  warehouse  or  boiler  house  is  likely 
to  be  little  affected  by  lapse  of  time.  Wooden 
buildings  subject  to  heavy  jars  or  the  action  of 
steam,  smoke,  acid,  vapors,  etc.,  are  likely  to  need 
replacement  often.  It  is  impossible,  therefore,  to 
give  any  hard  and  fast  figures,  but  in  the  main  it  may 
be  said  that  building  accounts  should  be  treated  as 
shrinking  in  value  by  a  certain  percentage  each  year 
— that  percentage  varying  from  perhaps  two  to 
twenty. 

Machinery,  as  already  suggested,  is  subject  to 
shrinkage  in  value  not  merely  because  of  actual 
wear,  but  because  it  is  likely  to  be  displaced  at  any 
time  by  inventions  rendering  it  out  of  date,  or  by 
changes  in  fashion  destroying  the  demand  for  its 
product.  Machinery  differs  from  buildings,  how- 
ever, in  that  to  a  certain  extent  it  may  be  kept  to  the 
original  value  through  the  medium  of  repairs  and  re- 
placements. It  can  usually  be  taken  apart  and  set 
up  with  a  new  gear,  a  new  shaft,  a  new  belt,  a  new 
feed,  and  what  not.  Indeed,  it  may  be  said  that  very 
few  machines  are  really  ever  worn  out,  for  unless 
they  are  of  extremely  simple  type,  constant  repairs 
and  replacement  of  parts  will  continue   their  ef- 


266  ACCOUNTING  AND  AUDITING 

ficiency.  It  is  mainly  because  better  machines  have 
come  upon  the  market  that  old  machines  are  dis- 
carded. In  allowing  for  depreciation,  therefore,  the 
task  is  to  consider  the  number  of  years  which  the 
machine  will  remain  useful,  and  to  figure  its  cost 
for  those  years  as  not  only  the  full  initial  cost,  but, 
in  addition,  all  expense  for  repairs  and  replace- 
ments. This  expense  must  be  distributed  evenly 
over  those  years,  for  clearly  to  charge  against  the 
profits  of  any  one  year  more  than  its  fair  share  of  the 
total  cost  of  the  machine  is  to  misrepresent  the  real 
profits  of  that  period.  The  main  question  arising  in 
the  treatment  of  depreciation  of  machinery  is  the 
method  of  calculation  of  the  total  cost  to  be  dis- 
tributed.   This  is  worthy  of  careful  examination. 

Repairs  and  replacements,  of  course,  which  not 
only  should  be  distributed  over  a  series  of  years  but 
will  actually  be  made  and  paid  for  in  those  years, 
should  be  charged  to  an  account  by  themselves.  This 
is  usually  called  ** Maintenance."  One  method  of 
treating  depreciation  is  particularly  well  illustrated 
by  the  former  common  practice  of  railroads.  Among 
the  total  operating  expenses  of  railroads  Mainte- 
nance of  Equipment — that  is,  repairs,  renewals  and 
replacements  of  locomotives,  cars,  snow-plows,  etc. — 
constitutes  about  fifteen  per  cent.  Since  the  total 
expense  of  this  sort  is  so  heavy  it  is  probable  on  a 
railroad  that  if  one  engine  requires  more  repairs  this 
year  than  usual,  some  other  engine  will  require 
fewer;  the  number  of  engines  is  so  large,  and  the 
nimaber  of  types  of  engines  is  so  great,  that  a  fair 
average  is  likely  to  be  maintained  one  year  as  com- 
pared with  another.     It  ha^  not  been  customary, 


DEPEECIATION"  267 

therefore,  for  railroads  to  make  any  theoretical  al- 
lowance for  depreciation — or,  at  least,  it  was  not 
customary  until,  a  few  years  ago,  the  Interstate 
Commerce  Commission  pressed  such  an  allowance 
upon  the  American  roads.  The  same  sort  of  thing  is 
true  of  maintenance  of  way  and  structures;  for 
though  the  cost  may  be  slightly  heavier  in  one  year 
than  in  another,  it  is  likely  to  run  along  fairly  close 
to  the  average.  This  method  of  treating  deprecia- 
tion, it  should  be  noted,  is  sometimes  the  only 
method  necessary.  If  the  property  is  comprised  of 
many  parts,  having  different  lifetimes,  and  therefore 
depreciating  at  different  rates,  it  may  chance  that 
each  year  a  good  many  parts  will  need  to  be  replaced 
— so  many,  in  fact,  that  the  general  efficiency  will 
never  decline  and  the  cost  of  maintenance  may  never 
vary  much  from  the  average ;  the  depreciation  on  old 
machines  not  replaced  will  be  offset  each  year  by  the 
excess  value  of  new  machines  over  those  which  they 
replace,  and  the  total  value  will  be  unimpaired.  To 
maintain  property  does  not  mean,  of  course,  that 
each  hit  of  property  is  maintained,  but  only  that  the 
property  as  a  whole  is  maintained.  To  improve 
twenty  locomotives  as  much  as  twenty  other  loco- 
motives decline  in  value  is  to  maintain  the  equip- 
ment. When  this  sort  of  thing  is  carried  out,  no 
further  provision  for  depreciation  is  necessary,  and 
maintenance  is  automatic.  It  is  necessary  to  realize, 
however,  that  in  very  few  enterprises  is  it  practi- 
cable each  year  to  keep  the  property  exactly  at  its 
original  value  by  repairs  and  replacements  and  at 
a  steady  cost.  The  Interstate  Commerce  Commis- 
sion refuses  to  assume  that  the  railroads  can  or  will 


WS  ACCOUNTING  AND  AUDITING 

do  so.  We  have,  then,  to  provide  for  the  actual  de- 
preciation which  repairs  and  replacements  cannot 
or  do  not  prevent. 

Let  us  turn  now  to  the  provision  for  the  esti- 
mated unavoidable  depreciation.  Each  of  several 
methods  of  making  the  necessary  calculations  has 
its  defendants.  The  most  obvious  of  these  is  a  sim- 
ple division  of  the  total  original  cost  of  the  machine 
by  the  number  of  years  which  it  is  expected  to  re- 
main in  use.  Two  objections  to  this  are  clear.  In 
the  first  place,  if  we  write  off  each  year,  beginning 
with  the  first  year,  a  sum  which  is  one  year's  pro- 
portion of  the  total  cost,  we  are  neglecting  the  fact 
that  money  is  always  capable  of  earning  interest, 
and  that,  therefore,  a  sum  laid  aside  each  year  in  a 
special  fimd  for  ultimate  replacement  will  at  the 
snd  of  the  time  have  increased  in  value  through  in- 
terest to  a  larger  sum  than  is  needed.  In  other 
words,  each  year's  share  except  the  last  may  as  well 
be  less  than  the  exact  arithmetical  proportion,  for 
the  accumulation  of  interest  will  make  up  the  de- 
ficiency. The  second  objection  to  this  method  is  that 
the  machine  does  not  depreciate  at  anything  like  a 
steady  arithmetical  rate.  This  method,  then,  is  pure- 
ly artificial,  and  although  it  produces  the  desired 
sum,  it  may  yet  result  in  a  considerable  unfairness 
as  between  different  years  of  the  life  of  the  machine, 
— especially  since,  as  we  shall  see  later  in  connec- 
tion with  other  plans,  it  neglects  several  important 
elements  of  what  is  going  on. 

A  second  method  is  to  use  what  is  called  a  sink- 
ing-fund device, — that  is,  to  find  by  calculation  a 
sum  of  money  which,  actually  set  aside  and  put  at 


DEPRECIATIOI^  269 

interest,  will  produce  the  desired  sum  at  the  end  of 
the  time.  This  may  be  illustrated  as  follows:  one 
dollar  set  aside  now  will,  at  4  per  cent,  interest, 
amount  to  $1.04  at  the  end  of  the  year ;  a  dollar  then 
set  aside  and  added  to  the  first  will,  at  the  end  of 
the  next  year,  amount  to  another  $1.04,  and  the  first 
dollar  will  in  the  meantime  have  become  in  value 
something  more  than  $1.08;  a  third  dollar  set  aside 
at  that  time  will  amount  to  $1.04  in  the  next  year, 
the  second  dollar  will  at  the  same  time  have  amount- 
ed to  something  more  than  $1.08,  the  first  to  some- 
thing more  than  $1.12;  and  so  on.  Adding  each  year 
a  dollar  and  the  accumulated  interest  of  preceding 
dollars,  we  get  a  considerably  larger  sum  at  the  end 
of  the  period  than  the  amount  of  money  invested. 
If  we  now  divide  the  amount  of  money  which  we 
wish  to  raise  at  the  end  of  the  period  by  the  total  ac- 
cumulation of  single  dollars  just  found,  we  shall 
know  what  number  of  dollars  set  aside  each  year  will 
accumulate  in  the  given  number  of  years  to  the  de- 
sired sum.  This  annual  sum  set  aside  is  called  a  sink- 
ing fund,  and,  as  we  have  seen,  will  be  steady.  The 
annual  payment  throughout  the  period  will  be  less 
than  the  total  amount  to  be  raised  divided  by  the 
number  of  years,  as  found  by  the  first  method,  for 
the  accumulations  of  interest  will  make  up  the  de- 
ficiency. 

A  third  method  is  to  recognize  the  fact  that  the 
machine  depreciates  much  less  in  the  early  years 
than  in  the  later,  and,  therefore,  to  distribute  the 
total  amount  of  depreciation  among  the  various 
years  in  an  increasing  proportion,  such,  for  instance, 
as  5  per  cent,  in  the  first  year,  10  in  the  second,  15  in 


270  ACCOUNTING  AND  AUDITING 

the  third,  20  in  the  fourth,  and  so  on  by  such  an  ar- 
rangement that  the  total  100  per  cent,  will  have  been 
written  off  in  the  expected  lifetime  of  the  machine. 
To  this  method  much  objection  can  be  found.  It  is 
true,  as  the  theory  assumes,  that  the  machine  will  de- 
preciate but  little  in  the  first  years,  and  rapidly  in 
the  last.  As  we  have^  seen  in  another  connection, 
however,  the  real  accounting  test  is  not  so  much 
the  change  in  the  value  remaining  as  it  is  in  the 
ability  of  each  year  to  endure  a  share  of  the  total  ex- 
pense; that  is  to  say,  we  are  not  so  much  concerned 
with  the  actual  depreciation  for  that  year,  which  is 
at  best  but  a  matter  of  guess  and  purely  arbitrary, 
as  with  the  amount  of  depreciation  which  that  year 
can  endiire  to  have  charged  against  its  products 
without  throwing  it  out  of  proper  relation  to  other 
years.  It  is  obvious,  in  the  first  place,  that  a  new 
machine  requires  fewer  repairs  and  replacements 
than  an  old  one,  and  that,  therefore,  the  direct 
charges  to  Maintenance  will  be  less  in  those  years. 
In  the  second  place,  such  a  machine,  since  it  is  of  the 
newest  type,  is  competing  probably  only  with  its 
equals  or  v^th  machines  of  an  older  type,  and,  there- 
fore, places  its  owners  either  on  an  equality  or  at  an 
advantage  as  compared  with  other  shops  using  older 
types  of  machines.  On  a  double  ground,  there- 
fore, the  business  can  afford  to  set  aside  a  con- 
siderable sum  out  of  the  product  of  the  early 
years  as  a  fund  for  ultimate  retirement  and  re- 
placen^t  of  the  machine,— because  repairs  are 
less,  ana  because  it  is  competing  at  an  advantage 
with  other  machines.  Yet  this  third  method  actually 
charges  less  against  the  product  in  the  early  years 


DEPRECIATION  271 

than  in  the  later,  and  in  the  later  years,  when  the 
machine  requires  many  repairs  and  at  the  same  time 
must  compete  against  new  machines  of  a  superior 
type,  it  charges  as  arbitrary  depreciation  a  heavier 
sum  than  in  the  early  years.  The  business  is  far  less 
able  to  take  out  of  product  in  the  old  age  of  a  ma- 
chine a  large  sum  for  repairs  and  for  a  replacement 
fund  than  in  the  early  years,  and  so  this  third 
method  is  really  unscientific  and  violates  in  its  as- 
sumptions a  most  obvious  fact. 

The  fourth  method  is  based  almost  entirely  on 
the  considerations  suggested  in  the  last  paragraph, 
that  is,  it  attempts  to  use  the  facts  which  the  third 
method  disregards.  Under  this  plan  the  amount  of 
depreciation  written  off  in  the  early  years  is  very 
much  heavier  than  in  the  later  because  the  business 
can  stand  such  heavy  depreciation  in  the  early  years 
and  cannot  in  the  later.  One  mathematical  mettiod 
of  making  the  calculation  of  annual  depreciation  is 
to  find  a  fixed  percentage  which  shall  be  applied 
each  year;  but  this  percentage  is  to  be  applied  not 
to  the  original  cost  of  the  machine,  but  to  that  orig- 
inal cost  less  the  previous  depreciation.  Suppose, 
for  instance,  a  machine  expected  to  last  five  years 
cost  $200  and  will  be  worth  $20  for  junk  when  sold. 
By  the  application  of  a  mathematical  formula  it  can 
be  learned  that  the  percentage  to  be  applied  is  about 
37.  This  will  give  us,  applied  to  the  $200  in  the  first 
year,  a  depreciation  of  about  $74  and  a  remaining 
valuation  of  $126.19;  in  the  next  year,  a  deprecia- 
tion of  about  $47  (that  is,  37%  on  the  $126.19),  and 
a  valuation  of  $79.62;  in  the  next  year,  37%  upon 
that  last  valuation  will  give  about  $29  additional 


372  ACCOUNTING  AND  AUDITING 

depreciation,  and  leave  a  balance  of  $50.24;  31%  ap- 
plied to  that  gives  us  a  depreciation  of  about  $19, 
and  a  valuation  of  $31.70;  and  a  final  37%  reduction 
gives  a  final  remaining  scrap  value  of  $20.  This  is 
distributing  the  charge  for  depreciation  over  the 
various  years  on  the  basis  of  what  each  is  best  able 
to  stand,  and  the  amount  subtracted  from  the  prod- 
uct should  leave  a  fair  sum  of  profit.  The  method 
of  calculation  for  this  percentage  is  rather  compli- 
cated, and  in  many  cases  is  hardly  worth  while,  but 
a  rough  substitute  for  it  is  found  readily  by  simple 
arithmetic.  If  we  add  the  numbers  representing  all 
the  years  which  the  machine  is  expected  to  last,  in 
this  case  5,  4,  3,  2  and  1,  the  sum  represents  the  de- 
nominator of  a  convenient  fraction;  if  we  each  year 
write  off  from  the  original  value  of  the  machine  a 
share  (of  the  total  depreciation)  represented  by  a 
fraction  having  for  its  numerator  the  number  of 
years  remaining  and  for  its  denominator  this  total 
number  of  years  just  indicated,  we  shall  attain  prac- 
tically the  desired  result.  To  illustrate,  in  this  case, 
as  we  have  just  seen,  the  sum  of  all  the  years,  5,  4,  3, 
2  and  1,  gives  us  a  denominator  of  15,  and  if  we  in  the 
first  year  write  off  5/15,  in  the  second  4/15,  in  the 
third  3/15,  in  the  fourth  2/15,  and  in  the  last  1/15, 
we  shall  have  written  off  in  the  end  the  total  15/15; 
and  we  shall  have  made  each  year  bear  a  proportion 
considerably  smaller  than  that  of  the  year  before. 
The  figures  of  depreciation  will  be  $60,  $48,  $36,  $24 
and  $12.  For  the  purpose  of  making  this  method 
clear  let  us  take  another  illustration.  Suppose  the 
machine  will  be  obsolete  in  ten  years.  We  add  to- 
gether 10,  9,  8,  7,  6,  5,  4,  3,  2  and  1.    This  gives  us  55 


DEPRECIATION  ^I'S 

for  a  denominator,  and  if  we  assume  that  the  ma- 
chine cost  $600  and  will  be  worth  at  the  end  of  the 
ten  years  $50  as  scrap,  we  get  $10  for  each  55th  of 
the  total.  In  the  first  year,  since  we  are  to  write  off 
10/55,  we  reduce  the  valuation  by  $100.  The  next 
year  we  are  to  write  off  9/55,  and  reduce  the  valua- 
tion further  by  $90,  and  so  on  in  a  decreasing  figure 
each  year  until  in  the  next  to  the  last  year  we  write 
off  $20,  and  in  the  last  year  $10.  Then  the  whole 
$550  has  been  subtracted  from  the  original  $600  and 
we  have  our  scrap  value  of  $50  remaining. 

It  is  obvious  that  at  best,  under  any  conceivable 
conditions,  our  writing  off  of  depreciation  is  to  a  cer- 
tain extent  arbitrary,  for  it  must  always  be  based 
on  a  mere  judgment  as  to  how  long  the  machine  will 
be  useful.  The  machine  may  actually,  so  far  as  its 
physical  substance  is  concerned,  last  far  longer  than 
we  expect,  or  it  may  wear  out  much  sooner;  and  new 
machines  may  not  come  upon  the  market  for  fifteen 
years,  though  we  base  our  calculations  on  ten, — or 
they  may  appear  in  three  years.  Since,  then,  our 
calculation  is  so  largely  guess  work,  it  is  absurd  to 
carry  the  figuring  of  depreciation  to  a  very  great  re- 
finement. Theoretically,  if  we  decide  that  we  should 
write  off  each  year  37%  of  the  preceding  valuation, 
we  ought  to  allow  for  the  fact  that  the  37%  if  set 
aside  will  accumulate  interest,  and  that,  therefore, 
a  smaller  sum  than  37%  will  suffice  for  the  purpose. 
Such  a  provision,  however,  would  be  finical,  for  since 
the  whole  calculation  is  a  mere  estimate,  an  allow- 
ance of  anything  annually  for  interest  is  quite  as 
likely  to  increase  the  discrepancy  between  the  fund 


^H  ACCOUNTING  AND  AtJDITING 

accumulated  and  the  amount  actually  needed  as  it  is 
to  decrease  it. 

The  substance  of  the  whole  matter  lies,  then,  in 
this:  depreciation  inevitably  goes  on  in  such  things 
as  machinery;  it  goes  on  with  increasing  rapidity; 
but  that  increasing  rapidity  is  in  part  offset  by  the 
fact  that  we  necessarily  in  the  monthly  conduct  of 
the  business  are  making  charges  to  Maintenance 
which  tend  to  keep  good  the  value  of  the  machine, 
and  in  part  by  the  fact  that  only  in  the  early  years 
can  the  machine  compete  successfully  with  other 
machines;  so  in  practice  it  is  desirable  that  the 
amount  of  depreciation  charged  against  the  product 
shall  in  each  year  be  a  decreasing  rather  than  an  in- 
creasing sum.  The  practical  task  is  to  determine  the 
probable  life  of  the  machine  and  to  calculate  a  rea- 
sonable rate  of  decrease  for  the  valuation. 

As  was  indicated  in  an  earlier  chapter,  even 
bonds  and  other  investments  are  likely  to  be  chang- 
ing in  value, — though  in  this  case  the  value  may  be 
increasing  as  well  as  decreasing  with  the  lapse  of 
time.  Whenever  any  contract  promises  to  yield 
more  than  the  normal  value  of  the  property  con- 
cerned, that  contract  is,  of  course,  worth  something 
to  the  holder.  Let  us  examine  this,  more  thoroughly 
than  before,  under  the  conditions  of  a  bond.  If,  for 
instance,  the  market  rate  of  interest  for  security 
of  a  certain  class  is  4  per  cent,  and  a  bond  promises 
to  pay  5  per  cent,  interest,  that  bond  will  bear  in  the 
market  more  than  the  par  value, — that  is,  it  will 
sell  for  something  more  than  its  face  value  because 
it  is  promising  to  give  each  year  a  larger  sum  than 
the  market  interest  on  its  face.    It  commonly  hap- 


iDEPRECiATIOIT  m 

pens  that  when  such  bonds  of  a  railroad  are  first 
issued,  though  the  face  of  the  bonds  calls  for  but 
$1,000,  people  will  pay  a  considerably  larger  sum 
than  that  into  the  coffers  of  the  railroad  company  in 
exchange  for  those  bonds.  In  fact,  the  railroad  by 
issuing  a  bond  has  promised  to  pay  the  purchaser 
not  only  his  $1,000  at  the  maturity  of  the  bond,  and 
the  normal  rate  of  interest,  say  4  per  cent.,  in  the 
interim,  but  still  a  larger  sum  by  the  amount  of  the 
higher  rate  of  interest;  and  for  this  the  purchaser 
of  the  bond  is  willing  to  pay.  The  premium  on  the 
bond,  that  is,  the  sum  paid  in  addition  to  $1,000,  is 
recognized,  or  should  be  recognized,  by  both  the 
purchaser  and  the  railroad  as  compensation  for  an 
annual  payment  which  we  may  call  an  annuity.  This 
annual  payment,  however,  will  cease  at  the  maturity 
of  the  bond  because  only  the  par  value,  or  $1,000, 
will  then  be  paid  (with  interest  accumulated  during 
the  last  period).  The  value  of  the  bond,  then,  is 
made  up  of  three  elements;  first,  the  value  of  the 
railroad's  promise  to  pay  $1,000  at  the  maturity  of 
the  bond;  second,  the  value  of  the  promise  to  pay 
normal  interest;  and,  third,  the  value  of  the  promise 
to  pay  extra  interest — that  is,  a  sum  in  excess  of  the 
normal  rate.  If  the  bond  called  for  only  the  normal 
rate  of  interest  on  the  par  value  of  $1,000,  it  is  ob- 
vious that  it  would  bear  no  premium  at  all,  for  the 
purchaser  would  be  getting  just  the  normal  rate  of 
interest  on  his  money  during  the  life  of  the  bond  and 
the  repajmient  of  his  principal  at  maturity. 

At  the  end  of  one  year  after  the  bond  is  issued, 
the  railroad's  promise  to  pay  more  than  the  market 
rate  of  interest  is  less  valuable  than  before,  simply 


^76  ACCOUNTING  AND  AUDITINO 

because  the  promise  is  now  of  shorter  duration  and 
not  so  many  payments  of  this  excess  interest  remain; 
at  the  end  of  the  second  year  the  promise  to  pay  ex- 
cess interest  has  shrunk  by  two  years'  value;  and 
so  on  until  the  end  of  the  time,  when  all  these  excess 
interest  promises  will  have  expired,  and  the  bond 
will  be  worth  just  par.  It  is  obvious,  therefore,  that 
if  we  wish  our  books  to  represent  the  value  of  our 
property  we  must  each  year  reduce  the  valuation  of 
all  bonds  which  have  been  purchased  at  a  premium; 
for  by  just  the  degree  of  their  approach  to  maturity 
there  has  been  a  shrinkage  of  value.  The  amount 
of  such  shrinkage  can  always  be  learned  readily 
from  published  tables  which  show  what  is  the  value 
of  bonds  paying  practically  any  common  rate  of  in- 
terest on  the  basis  of  what  is  assumed  to  be  the  mar- 
ket rate.  A  bond  table,  for  instance,  will  show  what 
is  the  value  of  a  5  per  cent,  bond  for  any  number  of 
years  or  half  years  on  the  assumption  of  a  market 
rate  of  interest  of,  say,  2%,  2%%,  21/2%,  23/4%,  and 
so  on  up  to  5%  and  6%.  Some  tables,  indeed,  show 
the  values  of  bonds  worked  to  bases  as  close  to  one 
another  as  one  hundredth  of  one  per  cent. 

If,  on  the  other  hand,  a  bond  pays  a  lower  rate 
of  interest  than  the  purchaser  believes  to  be  right 
for  the  kind  of  security  which  it  offers,  he  will  pay 
less  than  the  par  value  of  the  bond  for  just  the  same 
reason  that  in  the  other  case  he  pays  more.  If,  for 
Instance,  he  considers  that  in  view  of  the  risk  in- 
volved the  bond  ought  to  pay  5%,  but  it  actually 
pays  4%%,  he  will  pay  less  than  par  by  the  amount 
of  difference  of  interest  for  the  number  of  years  that 
it  has  to  run.    As  such  a  bond  approaches  maturity, 


DEPRECIATIOJiT  277 

therefore,  it  will  be  gradually  increasing  in  value; 
for  since  the  bond  promises  to  pay  $1,000  on  ma- 
turity, with  each  year's  lapse  of  time  that  valuation 
of  $1,000  is  getting  nearer,  and  the  length  of  time  for 
which  the  owner  will  be  receiving  less  than  the  mar- 
ket rate  of  interest  will  be  shorter.  If  the  bond  is 
good,  the  owner  is  sure  of  $1,000  at  the  end  of  the 
time,  and,  therefore,  he  will  at  every  new  closing 
of  his  books  increase  on  his  books  the  valuation  of 
the  bond  toward  the  thousand-dollar  point.  The 
amount  of  such  valuation  can  be  found,  as  for  bonds 
at  a  premium,  in  bond  tables. 

Similar  to  bonds  are  all  other  documents  promis- 
ing to  pay  a  fixed  sum  of  money  at  definite  intervals, 
such,  for  instance,  as  leases  and  contracts  for  the 
payment  of  royalties.  If  a  change  has  taken  place 
in  the  value  of  real  estate  so  that  property  which  we 
can  hire,  because  we  have  long  held  a  lease,  for  $1,000 
a  year,  is  really  worth  $1,500  a  year  to  us,  that  lease 
is  a  source  to  us  of  an  annual  saving  of  $500.  It  may 
be  worth  while,  indeed,  to  purchase  such  a  lease  of 
someone  else  and  pay  him  a  price  which  is  equivalent 
to  this  annual  $500  profit.  Obviously,  however,  as 
the  expiration  of  the  lease  approaches,  the  lease  is 
less  valuable;  for  if  it  was  taken  originally  when  the 
lease  had  five  years  to  run,  it  was  then  a  promise  of 
five  $500  savings,  the  next  year  it  is  good  for  only 
four  $500  savings,  the  next  year  for  three  $500 
savings,  etc.,  and  at  the  end  of  the  period,  since 
there  will  be  no  savings  remaining,  it  will  be  value- 
less,— ^unless,  indeed,  there  is  a  provision  in  the  lease 
for  its  continuance  at  the  option  of  the  holder.  We 
must  each  year,  therefore,  reduce  the  valuation  of 


278  ACCOUNTING  AND  AUDITING 

the  lease  on  our  books  in  proportion  to  the  reduction 
in  the  number  of  $500  savings.  This  reduction, 
however,  would  not  be  exactly  $500  because,  on  the 
principle  of  discount  previously  discussed,  $500  pay- 
able some  years  in  the  future  is  not  worth  $500  to- 
day. We  should  simply  find  the  present  worth  of 
each  of  these  $500  savings  and  each  year  reduce 
the  value  of  the  lease  by  the  present  worth  of  thie 
most  remote  saving — ^which  would  be  the  same  as 
the  present  amount  of  one  installment  less  the  in- 
crease in  the  value  of  the  other  installments  (due, 
of  course,  to  approaching  maturity). 

In  almost  all  businesses  there  are  frequent  pre- 
payments, such,  for  instance,  as  taxes,  insurance  and 
rent.  At  the  time  of  making  such  a  prepayment  we 
may  charge  it  to  either  a  property  account  or  a  nom- 
inal account  according  as  the  circumstances  seem 
to  make  worth  while.  If,  for  instance,  we  were  to 
pay  the  premium  on  a  five-year  fire  insurance  policy, 
we  should  recognize  at  the  time  of  the  entry  that  it 
was  not  all  a  charge  against  this  year's  revenue,  and 
we  should  be  likely,  therefore,  to  charge  it  to  a  prop- 
erty account  because  the  policy  is  a  good  asset  as 
long  as  it  remains  unexpired.  We  should  recognize, 
however,  each  year — or,  indeed,  each  fraction  of  a 
year,  if  we  attempt  to  determine  profits  oftener — 
that  a  certain  portion  of  that  has  expired  and  must 
be  written  off  the  books. 

It  is  not  enough  to  trust  to  memory  in  providing 
for  depreciation  at  the  end  of  any  earning  period. 
In  closing  the  books  at  such  a  time  one  should  run 
through  the  ledger  or  the  trial  balance  carefully  and 
see  whether  any  accounts  treated  as  real   include 


DEPRECIATION  279 

items  which  have  disappeared  either  entirely  or  in 
part  as  assets,  and  now  represent  only  explanations 
of  shrinkage  which  must  be  made  good  out  of 
product. 

The  method  of  entry  for  these  different  treat- 
ments of  depreciation  will  necessarily  differ.  So  far 
as  depreciation  is  prevented  by  maintenance,  the 
only  entry  is,  of  course,  to  debit  Maintenance  for 
actual  costs;  then,  as  .Maintenance  is  a  nominal  ac- 
count, it  is  closed  out  into  Profit  and  Loss,  and  the 
assets  remain  at  their  original  value — as  they  should, 
since  they  have  been  maintained  unimpaired.  So 
far  as  Maintenance  has  failed  to  keep  up  the  value 
of  property,  Depreciation  should  be  debited  as  an 
indication  of  shrinkage.  The  natural  credit  to  make 
at  the  same  time,  of  course,  is  to  the  account  repre- 
senting the  property  that  has  declined;  for  that  ac- 
count should  no  longer  stand  debited  with  property 
that  has  disappeared.  When  Depreciation  has  been 
carried  to  Profit  and  Loss,  therefore,  things  are  as 
they  should  be, — a  nominal  account  debited  for  the 
consumption  of  property  in  carrying  on  business, 
and  the  real  account  written  down  to  the  value  re- 
maining. If,  finally,  a  depreciation  fund  is  set  aside, 
out  of  product,  to  replace  the  exhausted  property, 
the  only  change  is  in  the  addition  of  another  entry 
for  the  investment  of  the  cash.  In  that  case,  the 
business  has  converted  one  kind  of  property  into 
another, — possibly  machinery  worn  out  in  convert- 
ing itself  into  goods,  goods  converted  into  money, 
and  money  converted  into  an  invested  fund;  and  in 
the  end  everything  is  the  same  (neglecting  profit  or 
loss  in  the  operation)  as  in  the  beginning  except  that 


280  ACCOUNTING  AND  AUDITING 

in  place  of  a  part  of  the  old  property  the  business 
now  has  a  fund  provided  for  the  purchase  of  new 
property. 

Whether  such  a  fund  should  be  invested  in  the 
business  itself  or  outside  is  a  question  not  of  account- 
ing, but  of  business  management.  It  must  be  real- 
ized, however,  that  a  fund  tied  up  is  in  one  sense  no 
real  fund  at  all. 


CHAPTER  XI 


PROFITS 


In  the  last  chapter  we  discussed  the  general  na- 
ture of  depreciation  and  the  methods  of  determining 
what  allowances  should  be  made  for  it.  In  general, 
it  may  be  said  that  the  profit  of  a  business  is  its 
income  from  operation  less  expenses  and  allowances 
for  depreciation.  To  learn  this  profit  seems  a  simple 
task  of  bookkeeping.  As  a  matter  of  fact,  however, 
the  determination  of  each  of  these  three  elements  is 
likely  to  involve  calculation  and  judgment  of  many 
things  not  normally  on  books  of  account.  In  every 
business  debts  are  constantly  accruing,  either  in  its 
favor  or  against  it,  long  before  they  can  well  be  en- 
tered on  the  books.  If,  for  instance,  taxes  are 
assessed  on  May  1,  and  the  close  of  the  business  year 
is  January  1,  to  the  expenses  otherwise  determined 
on  January  1  must  be  added  the  proportionate  charge 
for  the  year's  tax — ^that  is,  eight  months'  taxes  ac- 
crued but  not  due.  Similarly,  if  any  notes  outstand- 
ing bear  interest,  the  charge  is  day  by  day  increasing 
against  the  firm.  If  the  firm,  on  the  other  hand,  holds 
notes  bearing  interest,  the  amount  of  such  interest  is 
accruing  in  its  favor.  If  the  business  has  taken  dis- 
count on  notes  accepted  from  its  customers,  every 
day  brings  nearer  the  due  date  of  those  notes  and, 
therefore,  increases  their  value;  and  any  notes  which 

281 


282  ACCOUNTING  AND  AUDITING 

the  firm  has  had  discounted  for  it  by  others  are  by 
approaching  maturity  becoming  heavier  liabilities  of 
the  business — because  their  present  worth  is  more. 
Only  when  all  such  accruing  items  have  been  con- 
sidered is  it  possible  to  tell  exactly  what  has  been  the 
profit  or  loss  for  any  earning  period.  Among  large 
items  of  this  sort  are  likely  to  be  rents  and  royalties. 
It  may  chance  that  the  business  makes  payment  on 
lease  and  royalty  contracts  at  periods  far  removed 
from  its  own  fiscal  dates.  It  is  true,  of  course,  that 
if  the  amount  of  such  rents  and  royalties  is  neglected 
every  year,  and  is  constant  year  by  year,  no  error  will 
be  introduced  into  the  books  after  the  first  year; 
for  the  amount  entered  each  year  will  be  more  or  less 
than  the  amount  belonging  to  that  year  by  the  por- 
tion brought  over  from  the  last  year,  but  at  the  same 
time  it  will  be  less  or  more  than  the  proper  amount 
for  that  year  by  the  amount  carried  over  to  the  next 
year;  so  that  as  the  expense  is  steady  one  year 
after  another,  the  error  on  one  side  will  exactly  off- 
set the  error  on  the  other.  For  the  first  year,  how- 
ever, the  item  may  be  serious  and  should  be  allowed 
for,  and  when  once  allowed  for,  it  must  always  be 
allowed  for  or  error  creeps  in;  and  in  any  case,  if  the 
amount  varies  from  year  to  year,  considerable  error 
will  be  introduced  if  the  exact  figure  is  not  obtained 
for  the  exact  period  in  question. 

Persons  unfamiliar  with  accounts  may  be  in  some 
doubt  as  to  why  it  is  worth  while  to  draw  a  hard  and 
fast  line  and  say  that  certain  profits  belong  to  last 
year  and  certain  others  to  this.  If  it  were  true  that 
the  persons  who  lost  in  this  year  would  gain  in  the 
subsequent  years,  or  vice  versa,  it  would  not  usually 


PEOFITS  283 

matter  seriously,  even  though  the  line  were  not 
di^awn  with  absolute  accin-acy;  though  even  in  such  a 
case  it  is  desirable  that  a  man  shall  know  his  income 
with  exactness,  for  most  men  determine  their  expen- 
ditures with  some  regard  to  their  supposed  incomes. 
When,  however,  the  recipients  of  income  this  year 
are  somewhat  different  from  those  of  other  years,  it 
is  absolutely  essential,  in  order  to  attain  justice,  that 
there  shall  be  no  overstating  or  understating  of  the 
profits  of  any  year.  In  very  few  corporations,  ex- 
cept those  of  a  more  or  less  private  type  in  which  the 
stockholders  are  permanent,  is  it  true  that  the  profits 
held  over  and  understated  this  year  will,  when  finally 
distributed,  go  to  quite  the  same  persons  as  would 
have  benefited  by  the  early  distribution.  Stocks  of 
all  large  companies  are  frequently  changing  hands  in 
the  market,  not  only  because  of  speculation  but  be- 
cause of  changes  in  permanent  investment.  If,  in 
any  year,  the  profits  of  a  business  are  overstated  and 
the  amount  of  dividend  paid  is  larger  than  is  strictly 
correct,  the  gain  goes  to  the  stockholders  of  record 
at  that  time ;  and  this  gain  cannot,  of  course,  be  made 
up  by  a  payment  of  smaller  dividends  to  subsequent 
and  diiferent  stockholders.  Profits  hidden  by  care- 
less or  fraudulent  accounting,  on  the  other  hand,  are 
not  ultimately  distributed  fairly  if  persons  ignorant 
of  those  profits  sell  their  stock  at  a  price  based  on  its 
apparent  rather  than  its  real  value.  Watchful  in- 
vestors and  speculators  know  o:ften  that  a  business  is 
accumulating  reserves  which  will  ultimately  result 
in  larger  dividends ;  and  they  can  take  advantage  of 
the  ignorance  of  others  and  buy  at  an  unduly  low 
price.   They  get  dividends  which  should  go  to  former 


284  ACCOUI^TING  AND  AUDITING 

owners — or  should  have  been  paid  for  by  a  higher 
price  when  the  stock  was  sold.  If,  when  a  final  set- 
tlement is  made  between  partners,  the  property  on 
hand  is  understated,  the  partner  selling  out  receives 
less  than  his  due  share.  If  an  executor  in  settling 
an  estate  undervalues  the  property  of  that  estate, 
and  .by  will  the  income  belongs  to  one  person  and 
the  property  to  another,  that  which  ought  to  be  cred- 
ited to  the  property  may  be  included  by  this  error  in 
items  to  be  given  to  the  recipient  of  the  income.  Only 
an  absolutely  correct  statement  of  values  adjusted  to 
a  definite  time  provides  with  certainty  that  each  per- 
son shall  receive  the  proper  sum  in  any  bargain  or 
other  settlement  based  on  that  statement.  For  this 
reason  accounts  should  be  made  exact  and  no  ascer- 
tainable value  should  be  hidden. 

It  may  seem  to  some  as  if  the  method  of  deter- 
mining profit  on  merchandise,  as  shown  in  Chapter 
IV.,  confuses  the  profits  of  two  years  and  may  antici- 
pate future  profits  or  neglect  present  losses.  By  the 
method  described,  profit  on  sales  is  determined  by 
subtracting  from  purchases  the  valuation  placed  on 
present  stock  and  subtracting  this  remainder  from 
sales.  It  is  obviously  true  that  if  the  valuation  put 
on  merchandise  at  the  end  of  the  year  is  excessive, 
the  cost  of  sales  is  by  that  much  reduced,  and  profits 
are  by  that  much  overstated.  It  is  true,  therefore, 
that  an  overstatement  of  inventory  does  inflate  this 
year's  profits;  but  that  is  not  the  same  as  sa^dng 
that  this  year's  profits  are  dependent  on  a  realization 
in  the  future  of  the  inventory  value  now  placed  on 
merchandise.  If  the  inventory  value  is  correct  at  the 
day  the  inventory  is  taken — is  based,  that  is  to  say, 


PROFITS  286 

not  on  expected  selling  price  but  on  actual  cost  or  on 
present  wholesale  price  (whichever  is  lower), — this 
figure  subtracted  from  the  total  debits  to  merchan- 
dise shows  the  actual  cost  of  merchandise  han- 
dled during  the  year  past ;  and  that  cost  of  merchan- 
dise, when  subtracted  from  the  receipts  from  sales, 
shows  the  profit  on  the  goods  actually  sold  within  the 
year.  If  in  the  future  the  inventory  value  now 
placed  on  the  stock  is  not  realized,  a  certain  sum  will 
have  been  lost;  but  it  is  not  true  that  the  loss  has 
anything  to  do  with  the  operations  of  the  year  just 
considered.  That  loss  should  be  borne  by  the  year 
in  which  it  occurs,  and  it  occurs  not  in  buying,  but 
in  selling.  A  running  business  always  needs  a  work- 
^ing  stock  of  goods,  and  the  stock  left  on  hand  at  the 
end  of  the  year  is  presumed  to  be  essential  for  its 
continuance  into  the  new  year.  The  new  year  must 
take  those  goods  at  their  value  when  it  inherits,  and 
any  loss  sufered  on  the  sale  is  of  no  concern  to  the 
preceding  year.  Each  year  must  stand  on  its  own 
transactions,  and  though  we  are  never  sure  what 
will  be  the  ultimate  profit  on  the  total  merchandise 
purchased  within  ^  year,  we  may  learn  what  is  the 
profit  on  that  portion  sold  within  the  year,  and  that 
is  the  only  portion  with  which  the  year  is  concerned. 
The  task  of  valuation  is  to  get  things  correct  at  the 
time  it  is  made, — and  that  involves  allowance  for 
unsalable,  shopworn,  and  otherwise  depreciated 
stock.  It  should  stand  at  the  figure  which  is  to  be 
used  in  holding  next  year  responsible  for  its  in- 
heritance. 

In  most  countingrooms  profits  are  in  one  particu- 
lar misrepresented.    It  is  common  in  many  trades  to 


m  ACCOTJKTIl^G  AND  AIJDITIM 

offer  a  discount  for  early  payment  of  bills — this  dis- 
count ranging  from  one  to  seven  or  eight  per  cent. 
Usually,  as  has  been  indicated  in  the  chapters  on 
bookkeeping,  discounts  taken  by  customers  are  deb- 
ited to  Merchandise  Discount,  and  discounts  taken 
by  the  business  itself  are  credited  to  that  account.  Un- 
less one  analyzes  the  meaning  of  the  prices  entered 
on  bills,  this  seems  to  be  an  accurate  and  satisfactory 
method,  but  it  neglects  the  fact  that  the  billed  price 
for  the  goods  is  not  the  natural  price.  The  natural 
price  of  most  goods  manufactured  in  a  competitive 
market — and  nowadays  that  is  the  common  market 
— ^is  the  cost  of  production,  and  this  means  the  direct 
cost  for  labor,  for  materials,  and  for  other  manufac- 
turing service,  plus  interest  on  the  investment,  the 
salary  of  the  person  conducting  the  business,  and 
compensation  for  the  risks  involved.  If  a  man  can 
afford,  when  he  gets  immediate  cash  payment,  to  sell 
goods  at  $95,  but  actually  on  the  bill  enters  the  price 
of  $100  and  adds  a  statement  that  five  per  cent,  dis- 
count will  be  allowed  if  payment  is  made  within 
thirty  days,  it  is  obvious  that  the  difference  between 
the  $95  and  the  $100  has  nothing  to  do  with  the  cost 
of  production  of  the  goods.  The  extra  five  dollars, 
if  paid,  is  compensation  to  the  merchant  for  two 
things, — for  interest  because  of  delay  in  payment, 
and  for  the  additional  risk  he  takes  in  trusting  his 
customer  over  a  period  of  time.  It  is  not  true,  there- 
fore, that  a  business  house  loses  when  a  customer 
takes  a  discount;  for  allowance  of  that  discount  is 
no  more  a  loss  than  handing  back  change  to  a  cus- 
tomer who  in  buying  goods  over  the  counter  presents 
currency  of  excessive  denomination.    It  is  true,  of 


PROFITS  m 

(jotirse,  that  if  the  customer  did  not  pay  until  the  end 
of  thirty  days,  the  profit  would  be  five  dollars  larger, 
and  this  profit  is  lost  if  discount  is  taken;  but  it  is 
equally  true  that  if  a  customer  offered  five  dollars 
for  an  article  priced  at  four  dollars  and  a  half  and 
refused  to  take  the  fifty  cents  in  change,  the  business 
would  be  making  a  profit ;  and,  as  a  matter  of  fact,  if 
it  gives  him  his  change,  it  loses  what  otherwise  would 
be  profit.  Yet  it  would  be  absurd  to  say  that  change 
measures  loss.  It  is  equally  absurd  to  say  that  dis- 
counts given  are  losses.  The  ordinary  method  of 
charging  discounts  as  losses,  therefore,  entirely  mis- 
represents facts.  This  would  not  be  a  serious  matter, 
however,  if  it  were  true  that  calling  discounts  losses 
worked  equally  as  between  purchases  and  sales.  In 
both  cases  the  discount  is  an  amount  subtracted  from 
the  billed  price  of  the  goods :  for  sales,  a  neglect  on 
the  part  of  the  buyer  to  take  discounts  is  a  clear  gain 
to  the  seller — provided  payment  is  finally  made  at 
the  full  price;  but  it  is  not  true,  with  regard  to  pur- 
chases, that  the  taking  of  a  discount  is  a  gain  to  the 
buyer;  the  fact  is  that  the  failure  to  take  a  discount 
is  a  loss  to  the  buyer.  The  situation  can  be  under- 
stood only  if  we  realize  ahvays  that  the  natural  price 
of  the  goods  is  not  the  billed  price  but  the  discounted 
price.  If  the  selling  firm  collects  more  than  the  dis- 
counted price,  it  is  making  an  extra  gain;  on  pur- 
chases, however,  it  is  not  making  a  gain  when  it  pays 
the  discounted  price,  but  is  making  a  loss  when  it 
pays  the  billed  price.  Books  of  account,  therefore, 
should  regard  as  losses  only  discounts  neglected  on 
purchases,  and  should  represent  as  gains  not  dis- 


288  ACCOUNTING  AND  AUDITING 

counts  taken  on  purchases,  but  discounts  neglected 
by  customers. 

It  is  natural  to  think  that  if  the  discounts  taken 
on  purchases  are  as  large  in  amount  as  the  discounts 
allowed  on  sales,  the  business  has  lost  nothing  by 
neglecting  to  take  discounts  offered  to  it  by  its  cred- 
itors. A  little  thought  shows  that  this  is  entirely  a 
misunderstanding  of  the  situation.  It  is  not  neces- 
sary, in  order  to  make  profits  out  of  the  neglect  of 
customers,  that  one  shall  on  one's  own  side  neglect  to 
take  discounts  offered  by  one's  creditors.  The  two 
things  have  no  necessary  connection.  One  may  both 
profit  from  the  neglect  of  customers  to  take  dis- 
counts from  the  billed  price,  and  avoid  the  loss  from 
neglect  to  make  early  payments  on  one's  own  pur- 
chases. In  view  of  the  fact  that  the  discount  offered 
for  early  payments  for  goods  is  usually  at  a  consid- 
erably higher  rate  than  normal  interest,  it  is  the  part 
of  wisdom  for  any  business  with  good  credit  to  bor- 
row money  at  normal  rates  and  take  all  discounts, 
rather  than  to  allow  any  to  pass.  If  goods  are  sold  at 
such  terms  that  the  full  billed  price  must  be  paid 
in  sixty  days,  and  five  per  cent,  discount  will  be  al- 
lowed if  the  bill  is  paid  in  ten  days,  it  is  obvious  that 
the  five  per  cent,  is  allowed  for  fifty  days'  time — that 
is,  five  per  cent,  discount  is  allowed  if  the  bill  is  paid 
fifty  days  earlier  than  the  latest  time  mentioned. 
This  rate  of  five  per  cent,  for  fifty  days  is  equivalent 
to  thirty-six  per  cent,  a  year.  It  is  the  height  of  fool- 
ishness for  a  merchant  to  pa}^  thirty-six  per  cent,  a 
year  if  he  can  borrow  at  six  per  cent.  This  fact  is 
brought  home  to  merchants  usually,  however,  only  if 
their  books  show  them  what  is  the  actual  loss  each 


PROFITS  289 

year  by  neglect  to  take  discounts.  To  set  off  dis- 
counts neglected  by  customers  against  discounts  neg- 
lected by  the  business  is  to  count  a  chance  gain 
against  an  unnecessary  loss.  No  man  will  wisely  put 
those  two  things  into  the  same  scale ;  for  he  will  see 
at  once  that  he  may  as  well  realize  chance  gain  and 
at  the  same  time  escape  the  unnecessary  loss. 

The  method  of  accomplishing  this  is  to  shift  the 
usual  point  of  view  with  regard  to  discounts.  We 
have  no  interest  in  discounts  taken,  for  the  natural 
price  of  goods  is  based  on  the  assumption  that  dis- 
counts will  be  taken.  Profit  and  loss  lies  only  in  for- 
feiture of  discounts.  Since  merchants  do  not  know 
whether  discounts  will  be  taken,  however,  they  must 
bill  goods  at  the  full  price.  In  any  case,  therefore, 
whether  the  disccjunt  is  taken  or  not,  the  extra  sum 
should  be  deducted  ultimately  from  the  entry  to 
Merchandise.  It  is  desirable  that  goods  shall  stand 
on  the  books  at  the  lowest  price  at  which  they  can  be 
bought;  but  the  usual  method  enters  them  at  the  full 
price  and  then  makes  a  contra  entry  for  discounts 
actually  taken,  disregarding  the  discounts  not  taken; 
so  usually  the  merchandise  account  on  the  books  rep- 
resents neither  one  thing  nor  another,  for  some  goods 
are  entered  at  discounted  cost  and  some  at  full  billed 
cost.  Under  this  unfortunate  method  a  firm  with 
such  poor  credit  that  it  never  takes  discounts,  since 
it  debits  all  purchases  at  the  full  price  and  then  never 
makes  a  credit  for  discounts  offered,  has  a  higher 
valuation  on  its  books  for  its  merchandise  than  a  firm 
always  taking  discounts.  This  is  an  absurdity.  The 
only  proper  valuation  for  merchandise  is  the  natural 
price,  or,  as  has  been  suggested,  the  lowest  price  at 

A  &  A-19 


^90  ACCOUNTING  AND  AUDITING 

which  they  are  offered  for  sale.  The  proper  method 
is  to  enter  Merchandise  for  full  billed  price,  so  that 
the  books  of  both  parties  may  agree,  and  then  at  set- 
tlement make  a  contra  entry  for  the  largest  discount 
offered,  whether  that  discount  was  taken  or  not.  This 
leaves  Merchandise  with  a  proper  debit  or  credit. 
The  other  half  of  the  entry  will  depend  on  circum- 
stances. If  discount  is  taken  on  purchases,  the  entry 
is  merely  a  debit  to  the  creditor  for  the  amount  cred- 
ited to  Merchandise — that  is,  the  amount  of  discount; 
this,  with  the  cash  payment,  closes  the  creditor's 
account,  as  it  should.  If  the  discount  is  not  taken, 
the  debit  should  be  to  Neglected  Discount  for  the 
amount  credited  to  Merchandise;  for  this  amount  is 
an  extra  payment  made  to  the  creditor  above  the 
natural  price  of  the  goods  and  is  a  loss  due  to  neglect 
of  prompt  payment.  The  reverse  of  these  entries 
would  be  made  for  customers'  accounts, — with  the 
substitution,  however,  of  Collected  Discounts  for 
Neglected  Discounts.  Collected  Discounts  is  a  gain 
account.  It  must  go  in  part  to  offset,  at  the  end  of 
the  year,  losses  from  bad  debts — for  of  course  there 
are  no  such  losses  on  cash  sales.* 

Misapprehension  sometimes  arises  with  regard  to 
profits  on  contracts  for  future  delivery.  In  case  of 
a  dissolution  of  a  firm  while  contracts  are  in  progress, 
the  retiring  partner  naturally  thinks  that  the  profits 
already  gained  should  be  divided  as  a  part  of  the  gen- 
eral profits  of  the  business.    The  continuing  partner, 


*The  bookkeeping  for  these  entries  is  easy  to  provide.  Special  columns 
in  the  cash  book  for  Neglected  Discounts,  Collected  Discounts,  Merchandise, 
Dr.,  and  Merchandise,  Cr.,  furnish  the  medium  without  requiring  moM 
labor  than  that  required  by  the  common  treatment  of  discounts. 


MOFITS  S91 

on  the  other  hand,  naturally  thinks  that  the  profit  on 
any  contract  is  never  really  known  until  the  last 
stroke  of  work  has  been  done.  In  all  contract  w^ork 
unforeseen  circumstances  are  likelv  to  arise  and 
wipe  out  profits  previously  in  sight ;  it  is,  indeed,  in 
part  just  for  this  reason  that  so  much  work  is  done 
on  contract,  for  clients  believe  that  persons  experi- 
enced in  a  special  line  of  work  are  better  able  to  cal- 
culate, and,  therefore,  to  endure  risks,  than  are 
others.  It  is  true,  therefore,  that  there  is  no  such 
thing  as  known  profit  on  a  contract  until  the  contract 
has  been  absolutely  completed;  and  theoretical 
profits  should  not  be  entered  on  the  books  of  con- 
tracting firms.  In  the  case  of  dissolution,  where 
some  sort  of  settlement  must  necessarily  be  made, 
and  one  partner  or  the  other  insists  on  allowance  for 
apparent  profit  or  loss  on  contracts,  a  special  agree- 
ment should  be  made.  It  is  never  safe  to  assume  that 
merely  because  the  present  value  of  the  work  done 
shows  a  profit  of  perhaps  fifteen  per  cent,  on  its  cost 
the  whole  contract  will  show  the  same  percentage,  or 
anything  approaching  it.  The  only  correct  method  is 
to  reach  an  agreement  between  the  partners  as  to 
what  is  the  probable  cost  of  completing  the  work,  to 
add  this  sum  to  the  cost  of  the  work  already  done, 
and  to  consider  the  difference  between  the  total  and 
the  contract  price  as  profit  or  loss.  Since,  more- 
over, a  part  of  this  profit  will  be  actually  earned  in 
a  later  period — that  is,  in  completing  the  contract, — 
only  a  portion  of  this  profit  can  be  said  to  belong  to 
the  year  in  question.  If  the  partners  agree  on  such  a 
division  of  apparent  profits,  no  reason  can  be  given 
why  it  may  not  be  made;  but  for  any  partner  to  de- 


292  ACCOUNTING  AND  AUDITING 

clare  that  the  apparent  profit  is  actual,  and  to  insist 
that  he  shall  receive  his  pro  rata  share,  is  to  reason 
without  regard  to  the  common  experience  of  busi- 
ness. The  continuing  partner  may  justly  demand 
that  he  retain  a  considerable  margin  of  apparent, 
profits  to  cover  contingencies,  or  that  the  retiring 
partner  give  a  bond  to  cover  his  share  of  any  losses 
that  may  prove  to  have  been  sneered  on'  contracts 
in  which  he  was  interested.  Expenditure  on  an  un- 
completed contract  may  usually  be  counted  as  a  good 
asset  unless  the  contract  is  already  known  to  involve 
ultimate  loss — in  which  case  it  should  be  written 
down;  but  in  no  case,  even  in  corporation  accounts, 
should  profit  be  counted  on  a  contract  as  of  any  year 
before  completion  unless  the  work  is  so  near  com- 
pletion that  the  danger  line  has  been  safely  passed 
and  the  cost  of  completion  is  virtually  known — with 
a  safe  margin.  It  must  be  understood,  however,  that 
if  what  is  nominally  one  contract  be  really  several 
contracts,  each  with  its  own  contract  price  for  com- 
pletion, profit  may  be  safely  figured  on  each  as  soon 
as  settlement  for  it  is  made.  Losses  on  other  con- 
tracts completed  in  future  years  do  not  affect  the 
actual  profits  on  any  contract  completed  in  this  year. 
If  any  contracting  firm  has  knowingly  made  some 
unprofitable  contracts  in  order  to  secure  other  profit- 
able contracts,  the  situation  is  slightly  altered;  but 
it  would  be  hard  to  deny  a  partner's  or  a  stock- 
holder's right  to  profits  made  on  the  profitable  con- 
tracts if  these  were  completed  at  the  time  of  settle- 
ment and  the  unprofitable  contracts  were  still  in 
progress.    The  burden  of  proving  that  the  several 


PROFITS  3d8 

contracts  were  really  one  contract  would  be  on  the 
objector. 

One  item  which  is  likely  in  careless  bookkeeping 
to  be  treated  as  if  it  were  profit,  though  in  reality  it  is 
not  so  at  all,  is  premium  on  stocks  and  bonds  sold  by 
an  issuing  corporation.  As  has  already  been  indi- 
cated, premium  on  bonds  is  due  to  the  fact  that  the 
bonds  pay  interest  at  a  higher  rate  than  is  usual  for 
investments  of  equal  security,  and  this  higher  rate, 
being  of  the  nature  of  an  annual  payment,  has  a 
value  in  the  market — just  as  any  source  of  income 
has  an  ascertainable  value.  A  corporation  which  has 
issued  bonds  at  a  premium,  then,  has  simply  bounij 
itself  to  paying  an  unnecessarily  high  rate  of  interest 
for  a  number  of  years.  This  high  rate  is  not  a  loss, 
however,  for  the  premium  is  a  present  lump  sum 
given  as  compensation  for  the  high  interest  to  be 
paid  in  the  years  covered  by  the  life  of  the  bond. 
The  premium  is  therefore  just  as  much  an  obligation 
to  be  met  as  is  the  face  of  the  bonds — ^though  it  is  to 
be  met  not  in  a  lump  sum,  as  is  principal,  but  in  an- 
nual installments.  It  should  be  treated  on  the  books 
in  very  much  the  same  way  as  principal,  therefore, 
and  appear  on  the  balance  sheet  as  a  liability;  since, 
however,  it  is  a  liability  not  measured  by  the  par 
value  of  the  bonds,  and  not  represented  by  any  other 
common  sort  of  demand  or  claim,  it  should  appear  on 
the  books  under  a  title  w^hich  shall  show  exactly  what 
it  is;  and  as  each  year's  installment  of  interest  paid 
decreases  the  obligation  remaining  (since  fewer  an- 
nual payments  will  remain  to  be  made),  this  account 
should  be  written  off  until  at  the  maturity  of  tho 


294  ACCOUNTING  AND  AUDITING 

bonds  it  will  have  disappeared.  It  is  commonly  called 
^'Premium  on  Bonds  Issued/' 

Premium  on  stocks  issued  is  of  somewhat  dif- 
ferent nature,  for,  although  stocks  are  a  liability  of 
the  corporation  in  the  sense  that  the  account  repre- 
sents property  for  which  the  corporation  is  respon- 
sible, the  corporation  is  not  under  obligation  to  pay 
back  the  money  so  obtained.  Premium  paid  for  stock, 
then,  is  of  the  nature  of  capital  invested  by  the  sub- 
scribers, and  is  really  just  so  much  added  to  the  cap- 
ital investment.  To  consider  premium  on  stock  as 
profits  is  an  error  akin  to  treating  as  profits  the  orig- 
inal par  value.  There  is  no  sense  in  which  such  pre- 
mium can  be  considered  anything  else  than  capital 
investment,  and  it  must  always  appear  on  the  books 
and  on  the  balance  sheet  as  capital, — ^preferably  des- 
ignated under  a  title  indicating  its  origin,  such,  for 
instance,  as  ^^ Premium  on  Stock  Issued,"  or  ^^ Pre- 
mium Surplus." 

It  is  obvious  that  discount  on  bonds  issued  is  no 
more  a  loss  than  premium  is  gain.  We  saw  in  the 
chapter  on  depreciation  that  when  a  bond  is  bought 
at  a  discount  its  approach  to  maturity  raises  its 
value,  for  the  low  rate  of  interest  is  approaching  ex- 
piration; and  the  reason  it  sold  at  a  discount  was  that 
the  rate  was  too  low  for  the  risk  involved.  The  cor- 
poration issuing  the  bond,  in  other  words,  accepted  a 
low  price  for  the  bond  because  some  one  lent  money 
and  agreed  to  accept  less  than  the  rate  of  interest 
common  for  security  of  that  class.  The  corporation 
gets  back  in  a  low  interest  rate  what  it  loses  in  dis- 
count. The  exchange  is  a  fair  one.  The  discount  is 
a  good  asset — ^it  measures  the  value  of  immunity,  for 


PEOFITS  295 

a  period  of  years,  from  the  normal  interest  rate.  It 
may  appear  on  the  balance  sheet  as  *^  Discount  on 
Bonds  Issued."  As  the  bond  approaches  maturity, 
however,  the  value  of  the  asset  declines,  for  the  life- 
time of  the  immunity  is  declining,  and  the  account 
must  be  written  down. 

Discount  on  stock,  on  the  other  hand,  is  simply 
the  measure  of  deficient  capital — it  measures  the  de- 
ficiency of  actual  as  compared  with  nominal  capital. 
This  is  shown  in  the  chapter  on  the  peculiarities  of 
corporation  accounts. 

Depreciation  we  have  seen  to  be  one  of  the  ex- 
penses of  operation,  and  it  must  be  clear  that  the 
amount  to  offset  depreciation — either  when  repairs 
and  replacements  are  able  to  keep  the  property  in- 
tact, or  when  certain  smns  are  set  aside  for  replace- 
ment at  the  proper  time — must  be  met  out  of  the 
product  for  the  year:  it  is  not,  that  is  to  say,  to  be  tak- 
en out  of  the  profit,  for  profit  consists  of  what  is  left 
after  all  expenses  have  been  met;  and,  since  deprecia- 
tion is  one  of  the  expenses,  there  is  no  profit  until  the 
amount  of  allowance  for  depreciation  has  been  sub- 
tracted from  the  product.  This  distinction  is  funda- 
mental; and  neglect  of  it  has  often  led  in  business 
both  to  a  misstatement  of  facts  and  to  a  serious  mis- 
understanding on  the  part  of  many  business  men  as 
to  the  real  profitableness  of  an  undertaking.  It  must 
be  clearly  understood  that  all  allowances  for  depreci- 
ation are  just  as  much  costs  of  getting  product  as 
are  wages,  interest,  taxes,  insurance,  etc. :  only  when 
all  such  charges  have  been  absolutely  met  is  there 
any  profit  to  be  recognized.  The  reason  that  this  sit- 
uation is  not  fully  realized  is  that  very  commonly  the 


296  ACCOUNTING  AND  AUDITING 

depreciation  goes  on  out  of  sight  and  to  great  extent 
out  of  mind.  If  a  machine  produces  fifty  thousand 
articles  per  year  and  is  worn  out  to  the  amount  of 
$500  in  the  process,  it  ought  to  be  obvious  that  the 
five-hundred-dollar  shrinkage  in  the  machine  has 
gone  into  the  cost  of  the  articles  produced ;  in  other 
words,  instead  of  having  a  certain  amount  of  money 
in  a  machine  and  no  goods  as  we  had  at  the  beginning 
of  the  year,  we  have  at  the  end  of  the  year  a  smaller 
value  in  the  machine  and  an  equivalent  additional 
value  in  goods  or  in  what  the  goods  have  brought, — 
that  is,  the  machine  has  converted  its  iron  and  steel 
and  wood,  in  the  form  of  machinery,  into  product 
in  the  form  of  cotton  goods,  woolen  goods,  steel  tools, 
or  what  not.  The  machine  is  as  truly  consumed  as 
is  the  raw  material. 

When  we  have  counted  all  the  causes  of  shrink- 
age in  property,  and  all  the  causes  of  increase  in 
property — as  shown  by  the  earning  accounts,  such 
as  rent,  commission,  interest,  sales,  etc., — we  have 
a  definite  figure  of  profit  or  loss  at  the  end  of  the 
earning  period.  The  task  remaining  is  to  dispose 
of  those  profits  so  that  they  shall  be  available  for 
equitable  distribution  to  the  owners  of  the  business — 
whether  a  single  proprietor,  partners,  or  stock- 
holders. To  distribute  all  profits  outright,  at  least 
in  a  corporation,  is  almost  universally  considered 
bad  policy,  for  every  business  is  subject  to  fluctu- 
ations of  fortune.  Very  few  years  fail  to  give  results 
somewhat  higher  or  lower  than  the  average  of  a  se- 
ries of  years,  and  unless  the  owners  are  willing  to 
suffer  considerable  variations  in  the  amounts  actu- 
ally withdrawn  from  the  business  they  may  well 


PROFITS  297 

liold  back  in  prosperous  years  a  portion  ot  profits 
to  be  used  in  lean  years  for  eking  out  dividends. 
The  possibility  always  is  at  hand,  moreover,  that 
some  error  has  been  made  in  the  judgments  on  which 
are  based  the  calculations  determining  profit.  As 
we  have  seen,  the  figure  for  depreciation  is,  to  great 
extent,  an  estimate  based  on  pure  judgment.  If  new 
machinery  destined  to  supplant  old  is  invented  soon 
after  equipment  is  installed,  a  manufacturer  may 
find  his  assets  shrunk  in  value  by  many  thousands 
of  dollars.  It  is  the  part  of  conservatism,  even  after 
one  has  taken  out  of  product  all  one  thinks  necessary 
for  a  probable  shrinkage,  to  set  aside  a  sum  for 
unforeseen  and  unpredictable  contingencies.  Con- 
flagrations so  serious  that  insurance  companies 
are  not  able  to  meet  all  their  liabilities  occur 
now  and  then;  earthquakes  demolish  property; 
whole  trades  are  destroyed  by  changing  tastes, 
changing  habits,  changing  economic  and  political 
conditions.  All  these  things  show  that  it  is  wise 
for  a  corporation  or  other  busine'^s  organization  to 
set  aside  regularly  out  of  profits  in  all  years  except 
the  poorest  certain  sums  which  shall  enable  them  to 
meet  unforeseen  losses.  These  sums  ordinarily 
would  appear  on  the  books  as  subdivisions  of  the 
profit  and  loss  account.  As  we  have  already  seen, 
the  profit  and  loss  account  normally  will  have  a  credit 
balance,  and  if  dividends  paid  are  less  in  amount 
than  the  amount  standing  to  the  credit  of  that 
accoimt,  the  balance  is  simply  a  surplus  held  back 
for  contingencies.  That  amount  held  back  may  re- 
main either  under  the  head  of  Profit  and  Loss,  or 
under  some  new  title  to  indicate  its  purpose,  such 


298  ACCOUNTING  AND  AUDITING 

as  Reserve,  or  Depreciation  Reserve,  or  Security 
Reserve.  Sometimes  such  an  account  is  called  ^'Re- 
serve Fund,''  or  ^^Depreciation  Fund." 

It  must  in  any  case  be  realized  that  these  accounts 
are  purely  nominal.  They  explain  the  fact  that  of 
the  total  assets  of  the  business  some  are  profits,  and 
that  these  are  not  to  be  distributed  as  profits,  but 
are  held  for  special  purposes.  These  accounts  serve 
to  measure  the  amount  of  assets  set  aside  from  prof- 
its as  a  margin  of  safety.  If,  on  the  other  hand,  the 
corporation  wishes  to  set  aside  specific  assets  for 
specific  purposes — to  label  them,  so  to  speak, — it 
will  invest  some  of  its  assets  in  special  funds  and 
will  give  each  fund  a  name  to  indicate  its  purpose. 
In  such  a  case,  the  reserve  will  appear  on  the  credit 
side  of  the  balance  sheet,  to  show  the  origin  of  the 
property  (that  is,  profit  reserved),  and  the  property 
in  the  fund  will  appear  on  the  debit  side  of  the 
balance  sheet  as  an  asset.  When  the  item  does  not 
appear  on  the  debit  side,  no  specific  property  is  set 
aside:  that  is,  the  reserve  is  simply  an  excess  of 
assets  somewhere,  anywhere,  in  the  property — but 
not  designated  as  a  particular  bit  of  property. 

We  have  so  far  been  working  on  the  supposition 
that  the  books  represent  affairs  as  they  are.  Unfortu- 
nately, this  is  not  always  the  case  and  a  different 
result  is  sought  frequently  by  men  who  have  the 
highest  ideas  of  truth  and  justice.  Many  men  wish 
to  make  sure  that  they  have  not  overstated  their 
profits,  and  in  making  up  their  figures  for  the  end  of 
a  year  they  habitually  take  the  precaution  of  record- 
ing expenses  as  a  little  larger  then  they  really  be- 
lieve expenses  to  be.    The  result  of  this  is  to  assume 


PEOFITS  299 

that  the  property  is  iu)t  quite  so  valuable  as  it  really 
is;  that  is,  in  order  to  be  on  the  safe  side  they  assume 
depreciation  to  be  larger  than  it  really  is.  Some- 
times repairs  and  replacements  have  not  only  kept 
machinery  and  other  equipment  in  good  condition 
but  have  been  of  such  nature  and  of  such  extent  as 
to  make  the  property  really  better  than  it  was  before ; 
and  yet  the  full  cost  has  been  charged  to  mainte- 
nance as  an  expense.  On  a  railroad,  for  instance,  it 
is  common  to  improve  the  line  continually  by  put- 
ting in  heavier  rails,  better  ties,  better  ballast,  better 
bridges,  better  buildings,  and  yet  charge  the  cost  to 
operating  expense.  Obviously,  so  far  as  these  expen- 
ditures have  produced  a  better  road,  the  excess  can 
quite  properly  be  charged  to  capital.  When  this  is 
not  done,  on  the  contrary,  the  charges  are  included  as 
mere  repairs,  the  whole  cost  is  taken  out  of  the 
product  of  the  year,  and  profits  are  reported  smaller 
than  they  really  are.  The  excess  exists  in  the  road; 
but  since  this  excess  does  not  anywhere  appear  on  the 
books  as  an  asset,  it  constitutes  what  is  commonly 
called  a  ^^ secret  reserve." 

It  is  unquestionably  good  business  policy  to  pro- 
vide ample  reserve  to  improve  constantly  one's  facil- 
ities for  doing  business, —  unless,  indeed,  the  pro- 
prietors intend  to  retire  from  business ;  but  since  the 
purpose  of  accounting  is  always  to  show  facts,  any 
bookkeeping  process  by  which  reserves  of  any  sort 
are  kept  off  the  books  is  reprehensible.  It  is  nothing 
but  a  lie  pure  and  simple,  and  however  harmless  it 
may  be  in  intent,  it  is  unscientific.  Those  who  defend 
this  method  of  creating  reserves  commonly  do  so 
on  the  ground  that  stockholders  would   foolishly 


300  ACCOUNTING  AND  AUDITING 

demand  further  dividends  if  they  knew  the  f^cts. 
Whether  stockholders  are  wise  or  foolish,  they  have 
the  right  to  know  the  facts. 

One  reserve  created  with  the  full  knowledge  of  all 
interested  persons  is  often  so  far  misunderstood  that 
it  is  not  commonly  known  to  be  profit.  When  a  sink- 
ing fund  is  created  out  of  profits,  in  accordance  with  a 
legal  provision  in  a  bond,  for  the  redemption  of  debt, 
it  is  reported  on  the  balance  sheet  as  a  liability.  It 
is  established  on  the  books,  of  course,  by  a  debit  to 
Profit  and  Loss,  or  Surplus,  and  a  credit  to  Sinking 
Fund.  It  appears  to  be  the  mere  satisfaction  of  a 
legal  liability.  As  a  matter  of  fact,  however,  that 
legal  liability  is  not  really  a  new  one,  or  an  addition 
to  the  liability  covered  by  the  bond  itself ;  it  merely 
specifies  how  the  principal  liability  shall  be  dis- 
charged. The  sinking  fund  is  profit  when  set  aside, 
and  it  continues  to  be  profit  even  when  used.  Profit 
may  be  invested  in  the  payment  of  liabilities  as  well 
as  in  the  purchase  of  assets.  If  the  fund  has  been 
set  aside  out  of  profits  the  assets  must  be  in  the  busi- 
ness— else  there  were  no  profits  to  set  aside.  When 
these  assets  are  used  to  pay  debt,  they,  with  the  debt 
paid,  disappear  from  the  balance  sheet ;  but  the  sink- 
ing fund  remains  on  the  balance  sheet,  for  nothing 
has  happened  to  cancel  it.  It  is  now,  as  it  always 
was,  a  mere  measure  of  reserved  and  labeled  profits ; 
but  now  that  the  assets  which  constituted  the  real 
fund  have  been  applied  to  the  designated  purpose,  the 
fund  is  set  free  and  the  label  may  be  removed.  To 
invest  surplus  earnings  in  paying  off  debt  no  more 
destroys  their  character  as  earnings  than  does  pur- 
chasing merchandise  or  other  assets:  in  both  cases 


PEOFITS  i  301 

the  net  earnings  have  made  possible  more  net  assets. 
The  situation  is  quite  the  same,  except  for  the  con- 
venience of  the  label,  as  if  from  the  start  the  sinking 
fund  had  been  called  simply  ^^ surplus." 

We  must  now  note  that  it  is  'commonly  worth 
while  to  distinguish  between  diflPerent  kinds  of  profit 
and  loss.  We  have  been  considering  chiefly  the 
profits  of  normal  primary  operation;  but  many  busi- 
nesses have  not  only  common  outside  operations,  but 
extraordinary  occasional  profits  and  losses.  Ex- 
amples of  the  common  outside  operations  are  out- 
side bond  and  stock  investments,  and  ownership  of 
real  estate  not  used  in  the  business.  Let  us  first 
examine  extraordinary  gains. 

If  the  business  owns  land  and  buildings  which 
it  has  been  using  in  the  ordinary  course  of  its  trans- 
actions, and,  because  of  a  change  in  conditions  in  the 
town  or  city  where  it  is  located,  its  land  has  risen 
largely  in  value  and  it  sells  at  a  high  profit,  that 
gain,  though  distinctly  profit,  is  not  really  profit  of 
the  year  in  which  it  has  been  realized  nor  is  it  profit 
of  operation.  It  does  belong  to  the  proprietors 
or  stockholders;  but  if  the  books  allow  it  to  appear 
as  of  the  ordinary  type,  they  are  seriously  misrepre- 
senting the  facts.  Such  gains  may  be,  of  course,  dis- 
tributed to  stockholders;  but  the  books  should  show 
very  clearly,  and  the  declaration  under  which  the 
dividends  are  sent  out  should  state  very  clearly,  that 
this  is  of  an  extraordinary  nature,  the  like  of  which 
is  not  expected  to  occur  very  often. 

Because  things  of  this  sort  are  likely  to  happen 
now  and  then,  it  is  desirable  that  ordinary  profits, 
i.  e.,  profits  from  normal  sources,  shall  be  carried  to 


302  ACCOUNTING  AND  AUDlTlNa 

an  account  distinguished  from  general  Profit  and 
Loss.  Such  an  account  may  be  called  ^'Earnings." 
To  it  should  be  credited  all  earnings  from  the 
primary  operations  of  the  business — that  is,  revenues 
from  the  operations  which  the  business  was  prima- 
rily organized  to  carry  on, — and  to  it  should  be  debited 
the  expenses  which  have  been  incurred  in  securing 
those  revenues.  Tlie  balance  of  this  account  may 
then  be  transferred  to  an  account  called  ^'Income." 

Similarly,  to  Income  should  be  added  normal 
revenues  from  outside  operations,  like  interest  and 
dividends  on  investments,  and  rents  on  real  estate. 
The  balance  of  Income  may  then  be  transferred  to 
Profit  and  Loss,  and  there  meet  all  extraordinary 
gains,  such  as  that  assumed  above  on  real  estate. 

These  three  accounts  together  give  a  complete 
statement  of  the  business  of  the  year,  showing  how 
far  the  business  is  successful  in  its  primary  opera- 
tions, how  far  outside  interests  affect  its  profits,  and 
how  much  extraordinary  relations  have  yielded  it 
profit  or  caused  it  loss.  Many  business  men  deem  it 
wiser  in  the  case  of  extraordinary  profit,  such  as  that 
assumed  above  on  real  estate,  to  carry  the  gain 
directly  to  surplus  or  reserve  accounts,  and  thus 
avoid  the  temptation  to  distribute  it  as  dividends: 
they  think  that  this  should  always  be  reserved  and 
held  available  to  cover  extraordinary  losses  and  by 
so  much  relieve  the  ordinary  earnings  from  the 
necessity  of  contributing  to  such  reserves.  This  is 
a  matter  of  administrative  policy  which  affects  the 
accounts  only  as  the  accounts  must  register  it. 

When  we  turn  .to  the  other  side  of  this  aspect  of 
extraordinary  circumstances  and  look  at  losses,  we 


PEOFITB  303 

see  even  greater  need  of  making  distinctions.  If, 
instead  of  an  increase  in  value  of  real  estate,  the 
business  which  we  were  just  discussing  should  find 
that  its  property  had  fallen  heavily  in  value  because 
of  changed  business  conditions,  and  that  it  could 
no  longer  transact  its  business  in  the  old  quarters, 
it  would  probably  be  forced  to  purchase  or  hire  new 
property  at  far  greater  expense  than  could  be  cov- 
ered by  the  sum  realized  from  the  sale  of  the  old. 
This  loss  ought  not  to  be  charged  as  expense  of  the 
year  just  passed,  however;  it  would  be  a  loss  of  capi- 
tal, and  would  have  no  relation  to  the  profits  of  the 
year.  Though  this  loss  in  the  value  of  real  estate 
might  amount  to  $100,000,  the  profit  of  the  year 
might  still  be  $20,000;  for  the  actual  profits  of  con- 
ducting operations  are  not  affected  by  changes  of 
values  not  produced  by  tJiose  operations.  It  might 
be  true  that  if  the  business  were  obliged  to  sacrifice 
many  of  its  assets  in  the  purchase  of  the  new  real 
estate  required,  its  profits  in  succeeding  years 
would  be  very  much  lower,  for  it  might  not  then 
have  enough  working  capital;  but  that  fact  would  not 
in  the  least  alter  the  situation  for  the  year  just 
past.  The  profits  of  this  year  would  still  be  $20,000; 
and  the  shrinkage  for  the  future  would  be  due  to  a 
loss  of  capital  assets  because  of  changing  conditions, 
and  to  that  only.  It  is  feasible  for  a  concern  which 
has  suffered  such  a  loss  to  distribute  its  $20,000  earn; 
ings  in  the  form  of  a  dividend.  It  ought,  however, 
in  doing  so,  to  point  out  to  all  stockholders  that, 
although  this  is  an  earning,  the  enterprise  has  suf- 
fered a  loss  of  capital  to  the  amount  of  $100,000.  The 
stockholders  may  prefer  to  forego  dividends  for  a 


304  ACCOUNTING  AND  AUDITING 

while  and  to  restore  their  capital  out  of  earnings.  In 
many  cases  this  would  be  done.  What  shall  be  done, 
however,  is  a  matter  of  policy;  and  accounting  has 
only  to  record  the  facts.  The  accounts  must  show 
the  shrinkage  of  capital  until  capital  is  restored.  If 
the  surplus,  or  reserves,  are  not  large  enough  to 
cover  the  shrinkage,  a  deficit  must  be  shown  on  the 
balance  sheet — ^unless,  indeed,  the  amount  of  capital 
stock  is  reduced  by  calling  in  stock  and  issuing  either 
fewer  shares  or  shares  at  a  lower  Dar  value. 


CHAPTER  XII 


THE  INCOME  SHEET 


We  saw  long  ago  that  it  is  convenient  to  use  the 
trial  balance  as  a  basis  for  a  six-column  statement 
which  shall  show  profits  and  losses  and  resources  and 
liabilities.  The  loss  and  gain  columns  of  a  six- 
column  statement  may  in  a  sense  be  called  the  *  in- 
come sheet.''  As  already  suggested,  however,  cor- 
porations making  reports  to  their  stockholders  do 
not  usually  use  this  form,  but  substitute  a  different 
arrangement  of  the  items.  We  saw  in'the  last  chap- 
ter that  it  is  desirable  to  distinguish  on  the  books 
between  different  sorts  of  gain,  and  we  may  well 
continue  the  distinction  through  the  income  sheet. 
A  good  income  sheet  will  make  it  possible  to  com- 
pare the  gross  gain  from  the  primary  business  with 
the  cost  of  conducting  that  business,  so  as  to  show 
the  ratio  of  net  profit  of  that  primary  business  to 
the  amount  of  business  done;  it  should  show  the 
income  from  external  sources  of  revenue,  so  that 
these  may  be  compared  with  the  investment  in  exter- 
nal enterprises;  it  should  show  extraordinary  and 
chance  losses  and  gains;  and,  finally,  it  should  show 
not  only  what  is  the  final  net  income  but  what  is  done 
with  it, — that  is,  how  much  is  distributed  as  divi- 
dends and  how  much  is  laid  aside  for  surplus  or  for 
special  funds.    An  income  sheet  is  good  or  bad  in 

305 


A  &  A-20 


306  ACCOUNTING  AND  AtJDiTlNa 

form  just  in  the  degree  by  which  it  shows  clearly  the 
relations  between  these  various  elements  of  loss  and 
gain. 

An  income  sheet  may  take  the  form  of  either  a 
table  or  a  group  of  accounts.  We  have  seen  that  in 
ledger  accounts  no  subtraction  is  ever  made.  An 
income  sheet  presented  in  ledger  form,  therefore, 
will  show  three  separate  accounts,  each  with  its  bal- 
ance added  to  the  contrary  side.  A  sheet  constructed 
on  the  tabular  method,  however,  will  show  subtrac- 
tions and  no  transfers  of  balances.  Let  us  take  first 
the  ledger  form.  If  a  corporation  is  engaged  prima- 
rily in  trading,  the  first  part  of  the  income  sheet  is 
usually  called  the  ^^ Trading  Account;"  if  in  a  manu- 
facturing and  selling  business,  this  part  is  called  the 
** Manufacturing  and  Selling  Account;"  if  in  render- 
ing services,  as  is  a  railroad  corporation,  this  part  is 
called  the  ** Operating  Account." 

It  is  not  usually  necessary  to  place  the  items  com- 
ing from  outside  sources  of  income  in  an  account 
entirely  by  themselves,  for  the  addition  to  these  of 
the  net  balance  of  the  Trading  Account,  the  Manu- 
facturing and  Selling  Account,  or  the  Operating 
Account,  is  usually  desirable  in  the  end,  and  intro- 
duces no  confusion.  This  combined  account  is  usually 
called  the  ^* Income  Account."  Its  first  item  is 
usually  the  net  balance  brought  down  from  the  Trad- 
ing Account  (or  other  account  for  primary  income) ; 
to  this  credit  balance  are  added  all  other  sources  of 
income;  and  all  expenses  or  losses  from  normal  out- 
side relations  are  charged  to  this  account.  The  net 
balance  of  the  Income  Account  is  then  carried  as  the 
first  item  to  Profit  and  Loss. 


THE  INCOME  SHEET  Sor 

To  Profit  and  Loss,  after  the  balance  of  Income 
has  been  brought  down,  may  be  carried  income  from 
extraordinary  sources, — which  may  or  may  not  be 
available  for  dividends,  according  as  the  directors 
vote  to  distribute  that  extraordinary  gain  or  carry 
it  to  surplus.  If  this  is  not  destined  for  dividend 
purposes,  it  should  be  carried  at  once  to  surplus. 
Debited  to  Profit  and  Loss,  of  course,  are  extraordi- 
nary losses,  dividends  declared,  and  any  sums  trans- 
ferred to  special  reserve  accounts.  Unless  the  profit 
and  loss  accoimt  is  to  be  used  as  a  surplus  or 
deficit  account,  it  will  disappear  in  closing  the  books 
at  the  end  of  the  year.  If  it  is  so  used,  a  balance 
on  the  credit  side  is  surplus,  and  on  the  debit  side 
is  deficit.  To  use  it  as  a  surplus  account  is  undesir- 
able, however,  for  when  it  is  so  used  no  account  shows 
as  a  balance  the  net  gain  or  loss  for  a  single  year. 
The  net  gains  or  losses  for  each  year  are  lost  in  the 
mass  of  general  profit  and  loss  balance  and  must  be 
picked  out  if  they  are  to  be  known.  Profit  and  Loss 
may  better  be  opened  afresh  and  closed  for  each 
year ;  any  balance  should  be  carried  to  Surplus  or  to 
Deficit. 

This  Surplus  or  Deficit  is  clearly  a  connecting 
link  between  the  income  sheet  and  the  balance  sheet. 
The  income  sheet  is  intended  to  show  gains  or  losses 
occurring  during  the  year,  and  the  balance  sheet  to 
show  results  at  the  end  of  the  year.  So  far  as  gains 
are  not  distributed,  or  are  distributed  in  excess  of 
revenue,  the  balance  remains  at  the  end  of  the  vear 
and  therefore  belongs  on  the  balance  sheet. 

This  ledger  form  of  income  sheet  is  shown  below: 


kCCOVmim  AND  AtJDiTINft 

TRADING  ACCOUNT 


Purchases 

525,000      Sales 

675,000 

Wages  and  salaries 

Expenses 

Bad  debts 

50,000      Inventory 
25,000 
3,000 

100,000 

Depreciation 
Balance 

5,000 
67,000 

675,000 

675,000 

INCOME  ACCOUNT 

Losa  on  mortgage 
Balance 

2,000      Balance  Tra( 

68,000       Interest  and 

ling  Acc't 
Dividends 

67,000 
3,000 

70,000 

70,000 

PEOFIT  AND  LOSS 

Loss  by  defalcation 

10,000      Balance  Income  Acc't 

68,000 

Dividends 
Depreciation  fund 

50,000      Surplus 
10,000 

2,000 

70,000 

70,000 

In  the  case  above,  the  loss  on  the  mortgage  is 
considered  to  be  normal,  incidental  to  outside  opera- 
tions, and  is  therefore  charged  to  income.  The  loss 
by  defalcation,  however,  is  considered  to  be  extra- 
ordinary and  therefore  not  charged  to  either  Trad- 
ing Account  or  Income  Account.  It  reduces  the 
amount  of  surplus;  for  if  this  defalcation  had  not 
occurred  Surplus  would  have  been  credited  $8,000, 
whereas  it  is  actually  debited  $2,000.  The  total  in- 
crease in  reserve  (after  dividends  have  been  pro- 
vided for)  is  actually  $8,000,— $10,000  is  added  to  the 
depreciation  fund,  but  of  this  only  $8,000  has  come 
from  revenue,  for  $2,000  has  been  transferred  from 
the  general  surplus. 

Now  let  us  see  the  same  income  sheet  arranged 
in  tabular  form. 


5,000 

508,000 

3,000 
2,000 

67,000 

1,000 

68,000 
50,000 

10,000 
10,000 

18,000 
20,000 

THE  INCOME  SHEET  309 

Sales  $575,000 

Purchases  $525,000 

Inventory  .  100,000 

Cost  of  goods  sold  ,                    $425,000 

Wages  and  salaries  50,000 

Expenses  ^                                           25,000 

Bad  debts  3,000 
Depreciation 

Cost  of  sales 

Trading  profits 
Interest  and  dividends  on  investments 
Loss  on  mortgage 

Other  income 

Net  income,  available  for   dividend 
Dividend 

Surplus  for  the  year 
Loss  by  defalcation 
Added  to  depreciation  fund 

Net  reduction  of  general  surplus  2,000 

These  figures  are  the  same  as  the  others,  and 
show  the  same  groupings,  but  they  form  a  single 
series,  with  both  additions  and  subtractions,  where- 
as the  others  were  split  up  into  distinct  accounts 
with  many  contra  items. 

Very  few  corporations  publish  income  sheets  of 
much  value  to  one  who  is  trying  to  interpret  the 
accounts  from  the  outside.  It  is  common  for  corpor- 
ations to  combine  operating  expenses,  taxes,  and 
depreciation,  and  to  subtract  them  in  one  lump  sum 
from  the  gross  earnings.  The  result  is  a  figure 
which  is  virtually  unmeaning.'  Taxes  are  to  great 
extent  independent  of  management,  and  their  com- 
bination with  operating  expenses,  which  are  much 
affected  by  good  or  bad  management,  produces  a 
figure  which  means  neither  one  thing  nor  the  other; 
for  it  is  an  adequate  test  neither  of  the  government 


310  ACCOUNTING  AND  AUDITING 

demands  on  the  corporation,  nor  of  the  economy  of 
management.  Since,  moreover,  depreciation  allow- 
ances are,  as  we  have  seen,  largely  a  matter  of  judg- 
ment, and  here  they  are  not  shown  independently, 
we  know  from  these  figm'es  really  nothing  about  the 
policy  of  the  corporation  in  this  very  important 
particular.  A  fundamental  principle  of  good  report- 
ing is  that  items  which  are  the  result  of  different 
kinds  of  activity  shall  be  kept  separate.  An  income 
sheet,  to  be  of  any  value  to  a  reader,  must  show  the 
operating  figures  absolutely  independent  of  other 
figures;  then  the  reader  may  compare  the  total  ex- 
pense of  operation  with  the  total  gross  earnings,  and 
learn  about  what  percentage  is  maintained  between 
the  two. 

The  Interstate  Commerce  Commission,  which  is 
by  law  authorized  to  prescribe  the  forms  of  report 
for  railroads,  arranges  the  consolidated  income  fig- 
ures for  each  railroad  so  that  we  see  things  in  their 
natural  relations.  The  first  figure  is  the  gross  earn- 
ings from  operation — which  includes  all  earnings 
coming  from  the  direct  operation  of  the  road  inde- 
pendent of  income  from  extraneous  sources.  The 
next  item  is  so-called  operating  expenses,  which  may 
be  defined  as  those  expenses  incurred  in  acquiring 
the  gross  earnings  previously  shown.  The  difference 
between  these  two  figures  is  the  **net  earnings."  It 
is  customary  for  persons  attempting  to  judge  of  a 
railroad's  activity  to  find  what  is  called  the  ^^operat- 
ing ratio" — that  is,  the  percentage  between  the 
operating  earnings  and  the  operating  expenses.  On 
some  roads  this  percentage  will  run  higher  than 
eighty,  on  others  lower  than  fifty.    On  most  roads 


THE  IlSrCOME  SHEET  311 

it  falls  between  sixty  and  seventy-five.  If  we  know 
the  road  to  be  in  a  part  of  the  country  where  the 
expense  of  maintenance,  because  of  the  climate  and 
level  roadbed,  is  small,  and  where  labor  and  fuel  are 
inexpensive,  we  expect  to  find  a  rather  low  operating 
ratio.  Unless,  indeed,  we  know  a  road  to  be  excep- 
tionally well  kept,  or  to  be  recovering  from  a  period 
of  deficient  maintenance,  Ave  suspect  at  once  that 
an  operating  ratio  of  seventy-five  per  cent,  indi- 
cates wastefulness  in  operation.  If,  on  the  other 
hand,  we  find  a  road  whose  expenses  are  inevitably 
large — because  of  the  nature  of  the  country  through 
which  it  runs,  of  the  expense  of  its  fuel  (perhaps 
because  of  long  hauls),  and  of  the  high  rates  of 
wages, — w^e  are  a  little  suspicious  of  an  operating 
ratio  of  lower  than  sixty  per  cent.;  we  suspect  at 
once  that  false  economy  has  led  to  failure  to  keep 
the  roadbed  and  the  equipment  in  good  condition. 
These  illustrations  are  intended  not  to  pass  judg- 
ment on  railroads,  but  to  indicate  that  the  figures 
desired  on  an  income  sheet  are  those  that  can  be  com- 
pared,— that  is,  figures  pertaining  to  the  same  thing, 
as,  here,  earnings  from  operation  and  expenses  of 
operation. 

Recently  the  Interstate  Commerce  Commission 
has  required  roads  to  distinguish  between  strict 
transportation  operations  •  and  other  operations. 
Consequently  the  operating  revenues  and  operating 
expenses  heretofore  treated  each  as  one  item  now 
comprise  two  items  and  the  net  result  is  shown  for 
both  transportation  operations  and  outside  opera- 
tions.   These  results  recombined  show  net  revenue. 

From  this  net  revenue  is  subtracted  taxes.    Until 


312  ACCOUNTING  AND  AUDITING 

lately  taxes  were  taken  out  only  after  other  income 
had  been  added.  They  are  now  deducted  at  this 
point  because  primarily  they  are  fixed  operating 
charges. 

The  next  item  on  an  Interstate  Commerce  Com- 
mission income  sheet  is  usually  ^* other  income." 
This  includes  rents  earned,  interest  on  bonds  and 
dividends  on  stock  owned  by  the  road,  and  any  in- 
come from  miscellaneous  sources.  The  sum  of  the 
net  revenue  and  the  other  income  produces  gross 
income. 

We  have  now  to  subtract  the  expenses  or  costs 
independent  of  operation — such,  for  instance,  as 
interest  on  bonds  issued  by  the  road  itself.  The 
remainder  is  *'net  income."  Not  many  years  ago 
some  roads  were  in  the  habit  of  reporting  their  own 
declared  dividends  in  a  lump  sum  with  interest  on 
their  bonds.  From  one  point  of  view  these  things 
are  similar,  but  from  another  they  are  widely  un- 
like, for  bond  interest  is  obligatory,  whereas  the 
payment  of  dividends  is  voluntary;  and  the  only 
means  we  have  of  judging  how  far  the  distribution 
of  dividends* is  justified  is  to  see  what  relation  they 
bear  to  the  amount  available  for  dividends.  All 
involuntary  expenses  not  already  provided  for  should 
be  subtracted  from  gross  income  before  voluntary 
payments  like  dividends  are  introduced  to  confuse 
the  result.  When  taxes  were  included  in  this  group 
of  expenses,  the  group  as  a  whole  was  usually  called 
'* fixed  charges,"  for  these  would  usually  continue 
even  if  the  road  ceased  operation. 

The  net  income  is  of  course  available  for  divi- 
dends.   From  this  the  dividends  are  subtracted,  and 


THE  INCOME  SHEET  313 

t)  if  J  balance  is  surplus  for  the  year.  This  surplus  may 
be  reduced  or  eliminated  by  transfer  to  separate 
reserve  accounts  or  to  the  general  surplus.  An  in- 
come sheet  constructed  by  this  method  is  shown 
below. 


Gross  earnings  from  transportation 
Operating  expenses  for  transportation 

$32,046,656.56 
20,545,533.12 

Net  transportation  earnings 
Expenses  of  outside  operations 
Receipts  from  outside  operations 

$412,859.64 
336,509.44 

11,501,123.44 

Deficit  from  outside  operations 

76,350.20 

Net  revenue 
Taxes 

11,424,773.24 
867,209.03 

Net  operating  income 
Other  income 

10,557,564.21 
1,632,659.89 

Gross  income 
Interest,  rentals,  etc. 

12,190,224.10 
9,881,088.47 

Net  income,  available  for  dividend 
Dividends  paid 

2,309,135.63 
519,742.12 

Surplus  for  the  year 

1,789,393.51 

The  form  of  income  sheet  just  illustrated  does 
not  cut  up  the  total  into  groups  quite  similar  to  those 
previously  described,  but  it  produces  the  result  there 
sought.  In  every  case  the  accountant  must  decide 
what  is  the  clearest  form.  Persons  not  familiar  with 
bookkeeping  are  likely  to  be  puzzled  by  the  balances 
transferred  from  side  to  side  in  the  ledger  form, 
and  therefore  income  sheets  for  general  publication 
are  likely  to  serve  their  purpose  best  when  pre- 
sented in  a  single  table,  as  above  and  on  page  309. 

For  corporations  engaged  not  in  earning  profits 
but  in  administering  funds  for  general  w^elfare,  such 
as  public  libraries,  hospitals,  etc.,  income  from  ex- 
traordinary sources — ^legacies,  for  instance — ought 


314  ACCOUNTING  AND  AUDITING 

to  appear  in  connection  with  the  income  sheet  be- 
cause if  unrestricted  they  affect  the  total  amount 
which  these  institutions  may  currently  expend  for 
public  good.  Yet  if  these  legacies  are  not  needed 
for  current  expenses,  they  may  be  added  to  capital. 
Both  possibilities  should  show.  For  such  institutions, 
therefore,  the  income  sheet  is  far  more  complicated 
than  for  the  ordinary  type  of  commercial  enterprise. 
In  any  case  it  must  be  realized  that  income  from 
whatever  source  if  not  paid  out  in  dividends  or 
absorbed  by  expenses  must  go  ultimately  to  swell 
a  balance  on  the  balance  sheet;  and,  therefore,  we 
shall  find  the  income  sheet  and  the  balance  sheet 
tied  together  by  one  common  item  in  spite  of  the 
fact  that  usually  an  income  sheet  may  be  said  to 
contain  only  nominal  figures  and  a  balance  sheet  to 
contain  only  real  figures.  This  common  item  arises 
from  the  fact  that  the  final  balance  of  income  is  in 
one  sense  no  longer  nominal,  for  it  has  become  real 
when  at  the  end  of  the  year  the  books  are  closed  and 
the  amount  remaining  is  carried  as  a  claim  of  the 
stockholders  to  property  in  the  business.  This 
surplus  (or  reserve,  or  undivided  profits,  or  balance 
of  profit  and  loss)  belongs  to  the  stockholders  as 
much  as  any  items  credited  to  any  creditor  of  the 
company;  it  differs  from  capital  stock,  which  is  recog- 
nized as  a  liability,  only  in  that  the  capital  stock 
belongs  to  individual  stockholders,  as  shown  by  cer- 
tificates of  stock  stating  how  much  each  stockholder 
owns,  whereas  these  surplus  accounts  represent  sums 
not  yet  divided  among  the  stockholders  but  held  for 
stockholders  as  a  whole. 


CHAPTER  XIII 


THE  BALANCE  SHEET 


Let  US  now  examine  the  balance  sheet  and  see  in 
what  form  it  will  give  the  maximum  information 
about  the  condition  of  a  business.  The  purpose  of 
the  balance  sheet,  as  we  have  seen,  is  to  show  the 
amount  of  property  in  the  business,  or,  primarily,  its 
solvency, — that  is,  how  far  its  property  is  in  excess 
of  the  claims  against  it.  With  this  fact  in  mind  it  is 
easy  to  see  that  the  sheet  should  be  so  arranged  as 
to  indicate  not  only  what  is  the  ultimate  solvency — 
that  is,  how  much  in  the  course  of  time  may  be 
realized  on  property  as  an  offset  against  debts, — 
but  also  how  much  of  the  property  can  be  converted 
at  once  into  a  medium  for  paying  debts.  Many  a 
corporation  which  has  proved  perfectly  sound,  when 
given  all  the  time  it  wanted  to  make  collections  and 
to  sell  a  part  of  its  property,  has  been  forced  into 
bankruptcy  because  its  liabilities  were  immediate 
and  its  assets  were  rather  remote.  In  those  cases 
bankruptcy  was  simply  a  legal  device  to  extend  the 
time  for  paying  debts.  In  many  such  cases  every 
cent  of  indebtedness  was  paid.  A  balance  sheet  does 
not  really  perform  its  services,  therefore,  unless  it 
presents  items  so  arranged  that  one  may  see  by  it 
what  are  called  quick  assets  and  compare  them  with 
current  liabilities.    Indeed,  the  balance  sheet  will 

315 


316  ACCOUNTING  AND  AUDITING 

serve  its  purpose  best  if  it  is  cut  up  into  several 
groups  of  items.    The  arrangement  of  these  groups 
may  depend  in  part  upon  the  purpose  for  which  this 
particular  balance  sheet  is  presented.    A  person  who 
is  thinking  of  investing  in  a  business,  for  example, 
is  concerned  quite  as  much  with  its  ultimate  solvency 
as  with  that  which  is  immediate;  but  a  person  who 
is  thinking  chiefly  of  lending  to  it  is  concerned  more 
with  its  immediate  solvency.    On  general  principles, 
however,   persons   examining  a  balance   sheet   are 
concerned  much  more  with  the  really  ultimate  value 
of  the  property  than  with  its  immediate  use,  and, 
therefore,  they  are  usually  interested  primarily  in 
its  capital  items.    For  that  reason  the  capital  items, 
which  constitute  a  group  by  themselves,  are  usually 
placed  first;  these  are  followed  by  the  current  items; 
then  usually  by  items  accrued,  though  not  yet  due; 
and,  finally,  by  items  which  are  more  or  less  subject 
to  chance,  and  may  be  called  *' contingent."    Let  us 
analyze  a  balance  sheet  with  this  grouping  in  mind 
and  observe  its  arrangement. 

The  first  group,  or  capital  items,  on  the  assets 
side  comprises  the  fixed  property, — such  as  real 
estate,  plant  and  machinery,  permanent  investments, 
etc.  The  capital  liabilities  are  not  only  capital  stock, 
or  proprietor's  investment,  but  also  funded  debt,  or 
bonds  and  mortgages  running  for  a  term  of  years. 
Very  commonly  funded  debt  is  actually  permanent 
though  nominally  it  has  a  limited  term;  for  most 
corporations  pay  off  debt  by  borrowing  anew.  In 
many  lines  of  business  capital  assets  and  capital  lia- 
bilities are  nearly  equal.  The  reason  for  this  corre- 
spondence lies  in  the  fact  that  the  primary  function 


*HE  BALAKOE  SHEE*  Si* 

of  capital  is  to  furnish  the  means  with  which  busi- 
ness is  carried  on,  and  in  many  lines  of  business  the 
chief  means  is  permanent  property.  A  certain  excess 
of  capital,  however,  is  usually  necessary  in  the  form 
of  what  is  called  ' 'working  capital,"  or  property 
which  is  available  immediately  for  current  use.  It 
is  likely  to  happen,  therefore,  that  the  capital  liabili- 
ties will  be  in  excess  of  the  capital  assets,  the  differ- 
ence being  just  this  working  capital.  That  is  not 
always  the  case,  however,  because,  as  we  have  seen, 
siu*plus  may  have  been  accumulated,  and  this  surplus 
may  have  been  invested  in  the  form  of  capital  assets, 
such  as  real  estate,  stocks,  and  bonds.  In  that  case, 
of  course,  the  capital  assets  will  be  actually  in  excess 
of  the  capital  liabilities,  that  excess  arising  from 
surplus  which  is  really  capital,  though  not  usually 
included  in  the  capital  group  of  liabilities.  Surplus, 
indeed,  will  usually  stand  on  a  balance  sheet  in  a 
group  by  itself,  for  it  may  be  either  capital,  if  in- 
tended to  be  permanent,  or  current,  if  temporarily 
set  aside  with  the  intention  of  distributing  it  later 
as  dividends. 

The  current  items  would  include  usually  on  the 
assets  side  Bills  Eeceivable,  Accounts  Receivable — 
as  customers'  accounts  are  commonly  called — and 
cash.  Each  particular  line  of  business  is  likely  to 
have  its  own  current  assets  slightly  different  from 
those  of  other  lines;  a  railroad,  for  instance,  will  have 
sums  due  from  other  roads,  and  collections  due  from 
agents  and  conductors.  The  current  liabilities,  on 
the  other  hand,  will  include  Bills  Payable,  Accounts 
Payable — or  sums  due  to  creditors, — and  other  items 
peculiar  to  different  lines  of  business — such,  for  a 


318  ACCOUNTING  AND  AUDITING 

railroad  corporation,  as  sums  due  to  other  roads,  and 
audited  claims.  The  position  of  supplies  and  ma- 
terials on  a  balance  sheet  varies  with  different  lines 
of  business  and  with  different  firms  in  the  same  line. 
Some  accountants  assert  that  since  a  minimum  of 
supplies  and  materials,  such  as  raw  cotton  in  a  cotton 
mill,  pig  iron  in  a  foundry,  etc.,  is  essential  to  the 
conduct  of  business,  such  minimum  is  of  the  nature 
of  capital  assets  and  should  be  so  classified  on  the 
balance  sheet.  Other  accountants  believe  that,  though 
supplies  are  required  for  the  conduct  of  business, 
they  can  be  so  Teadily  converted  into  cash  that  they 
are  equivalent  to  current  assets, — even  though  there 
is  no  intention  of  selling  them.  Indeed,  the  position 
of  these  items  is  dependent,  like  a  great  many  other 
things  in  accounting,  on  the  point  of  view.  If  we  are 
considering  the  business  as  an  earning  machine 
whicn  IS  to  go  on,  supplies  are  of  the  nature  of  cap- 
ital, no  doubt,  and  yet  they  are  not  permanent,  as 
we  usually  expect  capital  items  to  be.  They  are 
working  capital.  If,  on  the  other  hand,  we  are  con- 
sidering the  balance  sheet  chiefly  as  it  throws  light 
on  immediate  solvency,  the  supplies  are  current 
items,  though  presumably  they  cannot  be  sold  for 
cost  if  their  sale  is  forced.  The  real  purpose  of  the 
current  group  of  items  in  the  balance  sheet  is  not  so 
much  to  distinguish  what  can  be  immediately  con- 
verted into  cash  as  to  show  those  items  which  in  the 
ordinary  conduct  of  the  business  can  be  turned  over 
readily  for  the  purposes  of  the  business;  and  surely 
materials  and  supplies  are  quite  as  available  for  the 
ordinary  conduct  of  the  business  as  are  Bills  Re- 


THE  BALANCE  SHEET  ^        319 

ceivable  and  Accounts  Receivable.  For  that  reason 
it  seems  best  to  place  them  in  the  current  group. 

The  next  group  of  items,  which  we  may  call 
*^ accrued/'  may  be  said  in  one  sense  to  belong  among 
the  current  items.  The  real  distinction  between 
these  two  groups  lies  in  the  fact  that  the  current 
items  have  been  already  entered  on  the  books  prior 
to  or  at  the  date  shown  for  the  balance  sheet  as  a 
whole.  The  accrued  items,  however,  are  not  sup- 
posed to  be  entered  at  that  time,  for  they  have  not 
reached  the  period  of  culmination.  To  consider  the 
current  items  as  a  whole,  therefore,  we  must  really 
add  all  accrued  items  to  those  contained  in  the  cur- 
rent group;  the  total  will  be  the  assets  immediately 
or  soon  available  and  the  liabilities  immediately  or 
soon  to  be  satisfied.  On  the  assets  side  the  accrued 
items  may  be  rents,  interest,  and  other  earnings, 
which  the  lapse  of  time  has  made  good  claims  of  the 
company,  though  they  are  not  yet  due;  and  on  the 
liability  side  the  same  sort  of  items  (usually  includ- 
ing taxes)  will  appear  as  accrued  against  the  com- 
pany, though  they  are  not  yet  payable. 

Concerning  the  treatment  of  the  last,  or  contin- 
gent, group  of  items,  much  difference  of  opinion  has 
arisen.  If  a  small  corporation  has  guaranteed  large 
liabiKties  for  some  other  corporation,  that  guarantee 
may  at  some  time  prove  a  heavy  drag  on  the  guaran- 
teeing company,  and  should  therefore  be  reported 
even  though  there  is  little  probability  that  it  will 
ever  cause  trouble.  It  is  rather  common,  for  illus- 
tration, for  railroads  to  guarantee  the  bonds  of  their 
subsidiary  lines.  Usually  the  subsidiary  line  is  ex- 
pected to  earn  enough  to  pay  its  own  debts;  but  if 


the  investing  public  has  not  faith  in  it,  the  control- 
ling corporation  may  undertake  to  create  a  good 
market  for  the  obligations  of  the  subsidiary  line  by 
guaranteeing  the  payment  of  interest,  or  of  both 
interest  and  principal.  These  guarantees  ought  to 
be  reported  in  some  form.  A  common  device  is  to 
report  them  at  the  bottom  of  the  balance  sheet  as 
contingent  items  on  the  liability  side.  As  an  offset 
against  these,  so  that  the  total  liabilities  of  the  whole 
sheet  shall  not  exceed  the  assets,  it  is  possible  to 
report  as  an  asset  the  claim  which  the  railroad  has 
against  the  subsidiary  road  in  case  the  guarantee  is 
fulfilled.  This  is  satisfactory  if  it  is  true  that  the 
asset  reported  in  the  contingency  group  is  an  ade- 
quate offset  to  the  liability.  This  often,  however,  is 
not  the  case,  and  the  road  which  offers  the  guarantee 
gets  in  return  for  that  guarantee  simply  a  claim 
against  the  earnings  of  the  controlled  road,  and  this 
claim  is  not  properly  susceptible  of  statement  as  an 
asset  in  quite  the  same  terms  as  the  liability  which 
it  is  supposed  to  cover.  It  is  far  better,  then,  instead 
of  reporting  the  contingent  liability  with  other  lia- 
bilities, offset  by  an  arbitrary  asset  on  the  other  side, 
to  leave  off  the  contingent  item  entirely  from  the 
balance  sheet  and  mention  it  in  a  foot-note  with  a 
statement  of  the  claim  which  justifies  it. 

Another  sort  of  contingent  item  rather  common 
is  that  for  notes  endorsed  and  discounted,  or  sold  to 
another  firm.  Frequently,  for  instance,  banks  in  the 
large  cities  have  made  upon  them  more  demands  for 
loans  than  they  can  well  supply  out  of  their  own 
funds,  and  at  the  same  time  banks  in  districts  re- 
moved from  financial  centers  have  more  funds  avail- 


THE  BALANCE  SHEET  321 

able  for  loans  than  the  demands  of  the  communities 
absorb.  A  natural  combination  is  made,  and  banks 
having  many  requests  for  loans  sell  to  their  corre- 
spondents in  other  places  some  of  the  notes  which 
they  have  purchased  at  a  discount,  and  by  that  means 
utilize  the  funds  otherwise  lying  idle  in  the  vaults  of 
their  correspondents.  In  other  words,  the  banks 
rediscount  the  notes  which  they  themselves  have 
discounted.  Usually  in  this  case  the  banks  which 
took  the  notes  originally  and  knew  about  the  people 
to  whom  the  loans  were  made  guarantee  payment  to 
the  banks  which  purchased  these  notes  from  them. 
This  guarantee  is  of  the  nature,  then,  of  a  contingent 
liability  of  the  large  bank;  but  it  is  offset  by  the  claim 
which  the  bank  has  and  believes  to  be  good  (else  it 
would  not  have  made  the  loan)  against  the  people  to 
whom  the  loan  was  originally  made  or  ac:ainst  the 
endorsers  of  the  notes.  It  is  customary,  therefore, 
for  national  banks  to  report  among  their  liabilities 
notes  rediscounted,  and  at  the  same  time  to  include 
in  their  loans  (that  is,  their  claims  against  business 
houses  for  loans  made)  these  same  notes  sent  to 
their  correspondents  for  rediscount.  The  result  is 
that  these  notes  appear  on  both  sides  of  the  balance 
sheet.  This  device  shows  all  the  facts,  and  indi- 
cates properly  what  assets  offset  the  contingent  lia- 
bilities. Similarly,  business  houses  that  have  dis- 
counted with  banks  notes  received  from  their  cus- 
tomers should  show  their  liabilities  for  ultimate  pay- 
ment if  their  customers  default.  Such  discounted 
notes  may  well  appear  on  both  sides  of  the  balance 
sheet  as  contingent  items.  If  the  makers  of  these 
notes  default,  the  business  must  pay,  and  hence  the 

A&A-21  ^    ^' 


Sn  ACCOUNTING  ANJt)  AUDITING 

liability  is  contingent;  but  in  that  case  the  notes 
revert  to  the  business  and  become  an  asset  on  which 
it  will  collect  if  it  can.  This  method  of  statement 
shows  just  how  much  is  outstanding.  The  probable 
losses  from  this  source  are  intended  to  be  covered 
by  Allowance  for  Bad  Debts  among  current  liabili- 
ties (counted  as  current  because  it  offsets  certain 
current  assets). 

In  municipal  accounts  it  is  rather  common  for 
contingent  items  to  appear  because  often  cities  re- 
quire that  contractors  shall  make  deposits  in  the 
nature  of  guarantees  that  they  will  carry  out  prop- 
erly their  contracts  for  street  construction  and  other 
public  work.  If  the  contracts  are  properly  ful- 
filled, these  sums  deposited  must  be  repaid;  if  not, 
they  will  be  used  to  offset  the  loss  which  the  city 
suffers  from  the  failure  of  the  contractor  to  per- 
form his  work  properly.  Usually,  therefore,  they 
are  only  loans  to  the  city.  On  the  other  side  of  a 
municipal  balance  sheet  there  are  likely  to  be  items 
of  taxes  so  long  due  that  there  is  probability  that 
they  will  never  be  collected.  It  is  thought  unwise 
to  write  them  off  as  uncollectible,  and  equally  un- 
wise to  include  them  among  current  assets.  The 
contingent  group  on  a  balance  sheet  furnishes  a  con- 
venient place  for  reporting  items  of  this  sort.  All 
contingent  items  must  be  judged  with  due  consid- 
eration of  the  nature  of  the  contingency. 

Attention  has  already  been  called  to  the  fact 
that  normally  one  item  on  the  balance  sheet  is  de- 
rived from  the  income  sheet.  The  surplus,  as  shown 
by  the  income  sheet,  is  a  liability  of  the  company  to 
stockholders,  and  must  be  reported  as  such.     As 


THE  BALANCE  SHEET  323 

appearing  on  the  income  sheet,  however,  it  is  re- 
lated only  to  the  particular  year  in  question;  but  if 
any  surplus  has  been  accumulated  in  preceding 
years,  the  surplus  for  the  current  year  added  to  the 
surpluses  of  other  years  will  produce  a  new  total 
which  will  appear  on  the  balance  sheet,  and,  there- 
fore, the  figure  on  the  balance  sheet  will  be  different 
from  that  on  the  income  sheet.  The  surplus  on  the 
income  sheet,  in  other  words,  is  a  surplus  from  one 
year,  but  the  surplus  on  the  balance  sheet  is  an 
accumulated  surplus  of  all  years.  The  same  thing 
is  true  with  regard  to  deficits,  of  course,  for  both 
income  sheet  and  balance  sheet  may  have  deficits  as 
well  as  surpluses;  and  a  deficit  on  the  income  sheet, 
combined  with  a  larger  surplus  on  last  year's  bal- 
ance sheet,  still  leaves  a  surplus  for  this  year's  bal- 
ance sheet,  whereas  a  deficit  on  the  income  sheet, 
combined  with  a  deficit  on  last  year's  balance  sheet, 
produces  a  larger  deficit  on  this  year's  balance 
sheet,  and  a  deficit  on  the  income  sheet,  combined 
with  a  smaller  surplus  on  last  year's  balance  sheet, 
produces  a  deficit  on  this  year's  balance  sheet.  As 
was  indicated  in  the  last  chapter,  moreover,  a  deficit 
on  the  balance  sheet  is  still  consistent  with  one  kind 
of  surplus  on  that  sheet.  A  surplus,  as  we  saw,  may 
originate  not  only  out  of  profits,  but  from  a  contri- 
bution of  capital,  as  when  stock  is  sold  at  a  pre- 
mimn;  and  a  deficit  raay  have  originated  in  either 
operations  or  extraordinary  outside  losses ;  so  if  both 
have  occurred,  confusion  should  be  avoided  by  report- 
ing them  separately.  The  desirable  thing  is  to  report 
them  not  only  so  that  each  shall  be  clearly  shown,  but 
so  that  each  shall  be  read  in  connection  with  the  other. 


S24  ACCOUNTING  AND  AUDITING 

If  both  must  appear,  therefore,  one  as  a  surplus  capi- 
tal contribution,  and  the  other  as  an  operating  deficit, 
each  should  have  an  appended  note  calling  attention 
to  the  extent  of  the  other ;  otherwise  a  careless  reader 
of  the  report  may  be  much  impressed  by  one  and  fail 
to  observe  the  other. 

In  the  minds  of  many  persons,  a  balance  sheet  is 
confused  with  a  statement  of  resources  and  liabili- 
ties. Theoretically,  a  balance  sheet  and  a  statement 
of  resources  and  liabilities  are  the  same  thing;  but 
practically  they  are  not  always  so.  A  balance  sheet 
ought  theoretically  to  show  not  only  what  is  the 
exact  state  of  affairs,  but  what  is  the  exact  condition 
of  the  books;  and  yet  not  always  can  the  books 
show  for  each  particular  branch  of  the  business  just 
what  is  the  state  of  affairs.  It  is  impossible,  for 
instance,  to  reduce  on  the  books  the  amount  of 
claims  against  customers;  and  yet  the  accountant 
may  believe  that  possibly  five  per  cent,  of  those 
claims  will  never  be  paid.  The  bookkeeping  diffi- 
culty is  that  he  is  never  sure  which  particular  claims 
will  fail  of  payment,  and,  therefore,  he  cannot  be 
sure  which  accounts  ought  to  be  written  off.  He 
must  still  maintain  those  claims  on  his  books  at  the 
full  value,  though  he  knows  that  as  a  whole  they 
will  yield  only  ninety-five  per  cent,  of  the  full  value. 
A  device  must  be  provided  therefore  to  reduce 
assets  by  the  amount  of  expected  shrinkage  in  these 
claims;  and  yet  if  that  reduction  is  made  by  sub- 
tracting from  any  figure  of  assets,  the  balance  sheet 
is  out  of  accord  with  the  books.  We  saw  long  ago 
that  subtraction  is  practically  never  performed  in 


THE  BALANCE  SHEET  325 

bookkeeping,  and,  therefore,  we  fall  back  on  the 
device  of  increasing  the  other  side.  The  desirable 
thing  to  do  here,  therefore,  is  to  show  on  the  credit 
side  an  account  representing  the  probable  loss  from 
bad  debts,  and  consider  this  a  liability  of  the  busi- 
ness. This  is  commonly  called  ''Reserve  for  Bad 
Debts."  Its  appearance  on  the  liability  side  of  the 
balance  sheet  indicates  that  the  business  is  respon- 
sible to  make  good  this  shrinkage,  and  that  the 
amount  has  been  subtracted  from  income  to  satisfy 
that  responsibility.  In  a  sense  this  liability  is  quite 
as  much  a  subtraction  from  assets  as  is  the  liability 
to  creditors  from  whom  purchases  have  been  made. 
No  one  objects  to  reportirig  the  assets  at  the  nom- 
inal figure,  even  though  heavy  liabilities  are  out- 
standing, if  only  the  liabilities  are  properly  shown 
on  the  balance  sheet.  So  when  it  is  realized  that 
this  reserve  for  bad  debts  is  exactly  similar  in  nature 
— so  far  as  the  responsibility  of  the  business  is  con- 
cerned— to  debts  due  outside  creditors,  this  form 
of  reporting  probable  shrinkage  in  claims  against 
customers  is  unobjectionable.  The  only  difficulty  in 
this  connection  is  that  this  is  just  what  some  per- 
sons are  unable  to  realize.  They  are  in  danger  of 
believing  that  this  reserve  for  bad  debts  is  simply 
profits  set  aside  as  an  extra  reserve  fund  for  safety's 
sake,  and  that  it  probably  will  never  be  needed  for 
the  purpose  designated.  In  such  a  case,  obviously, 
the  amount  will  be  thought  to  be  a  sort  of  contingent 
siu^plus;  whereas,  as  a  matter  of  fact,  this  amount 
must  be  made  good  not  out  of  the  profits  but  out  of 
product, — that  is,  there  can  be  no  profits  until  this 
amount  has  been  covered.    For  this  reason  it  would 


326  ACCOUNTING  AND  AUDITING 

be  better  to  call  this  account  ' 'Allowance  for  Bad 
Debts."  This  suggests  the  fact  that  it  represents 
a  probable  loss. 

The  difficulty  just  suggested  with  regard  to  re- 
serve for  bad  debts  is  found  almost  universally  in 
interpreting  balance  sheets  w^herever  the  one  who 
reads  the  sheets  is  not  quite  familiar  with  the  ac- 
counting policy  of  those  who  construct  them.  There 
is  no  uniformity  of  custom  with  regard  to  reserve 
accounts  appearing  as  liabilities  on  balance  sheets 
of  corporations.  Some  corporations  set  aside  annu- 
ally from  profits  a  sum  which  they  entitle  '^  Reserve 
for  Depreciation."  This  is  merely  profits  which  are 
held  back  in  order  that  the  corporation  may  be  on  a 
secure  footing,  so  that  in  case  of  inventions  dis- 
placing machinery  it  may  have  a  fund  available 
for  making  good  that  loss;  but  such  inventions  are 
not  expected,  and  such  depreciation  is  not  believed 
to  be  really  necessary, — it  is  pure  profit  held  for  an 
improbable  contingency.  Other  corporations,  on 
the  other  hand,  do  not,  with  the  progress  of  depre- 
ciation, reduce  the  book  valuation  of  their  prop- 
erty, but  think  they  have  made  adequate  provision 
for  such  depreciation  by  establishing  among  their 
liabilities  a  reserve  account  which  measures  the 
amount  of  depreciation  of  assets.  That  is,  they  have 
deliberately  and  intentionally,  and  they  believe  jus- 
tifiably, left  on  their  books  as  a  valuation  of  assets 
a  higher  figure  than  is  real,  and  have  attempted  to 
offset  this  overstatement  of  assets  by  establishing 
on  the  liability  side  of  the  accounts  an  item  measur- 
ing the  depreciation.  To  put  this  in  another  way, 
knowing,  as  they  do,  that  a  credit  is  an  offset  to  a 


THE  BALANCE  SHEET  327 

debit,  and  that  the  balance  between  them  is  the 
actual  figure  of  property,  they  leave  their  asset 
accounts  at  the  original  figures  and  credit  a  reserve 
account  for  the  amount  of  depreciation.  It  is  true 
that  by  combining  the  asset  account  and  the  reserve 
account  one  does  produce  a  figure  which  is  the  exact 
value  of  the  property;  but  unless  one  knows  that 
this  reserve  account  is  merely  a  sum  to  be  deducted 
from  assets  and  is  not,  as  it  appears  to  be,  a  sum  set 
aside  out  of  profits,  one  is  likely  to  be  misled  in 
one's  judgment  of  the  value  of  the  property  owned. 
Such  a  depreciation  account  or  depreciation  reserve 
must,  like  our  reserve  for  bad  debts  just  discussed, 
come  out  of  product  before  there  is  any  profit; 
whereas  the  other  kind  of  reserve  for  depreciation 
suggested  a  moment  ago — a  mere  labeling  of  profits 
to  show  that  they  are  to  be  kept  for  a  remote  con- 
tingency— is  an  indication  that  the  assets  of  the  busi- 
ness are  intact,  and  are  by  the  amount  of  this  account 
greater  than  the  amount  of  capital  subscribed.  It 
is  unfortunate  that  such  differences  of  accounting 
methods  prevail  among  corporations;  the  only  con- 
clusion we  can  draw  is  that  one  must  know  what  is 
represented  by  any  such  reserve  account  before  one 
is  in  a  position  to  tell  even  from  the  company's  own 
books  what  is  the  value  of  property  on  hand. 

A  so-called  statement  of  resources  and  liabilities 
differs  from  a  balance  sheet  in  that  it  pretends  only 
to  show  supposed  facts  in  a  simple  way,  regardless 
of  the  technicalities  of  bookkeeping.  It  will  show, 
for  instance,  the  prohable  value  of  accounts  receiv- 
able, rather  than  book  figures.  This  seems,  at  first 
thought,  better  than  a  balance  sheet.    The  difficulty 


328  ACCOUNTING  AND  AUDITING 

is  that  it  is  based  wholly  on  someone's  judgment.  It 
gives,  moreover,  no  statement  for  the  basis  of  that 
judgment.  Most  business  men  prefer  their  own 
judgments  to  somebody's  else.  They  like  to  know 
what  the  books  show.  Then  they  can  make  allow- 
ances to  suit  themselves.  "When  Accounts  Receiv- 
able is  shown  on  one  side  of  the  balance  sheet  and 
Allowance  for  Bad  Debts  on  the  other,  the  reader 
sees  both  the  book  figures  and  the  judgment  of  the 
managers.  A  statement  of  resources  and  liabilities 
is  a  good  thing  to  report,  but  it  should  supplement 
and  not  supplant  the  balance  sheet.  In  any  case, 
however,  corporations  should  be  required  by  law 
to  indicate  clearly  whether  depreciation  and  shrink- 
age have  been  subtracted  from  the  cost  of  their 
property,  or  have  been  treated  as  a  liability  to  be 
met  out  of  earnings.  The  clearest  form  for  showing 
this  is  a  statement  of  resources  and  liabilities  which 
shall  contain  not  offsets,  but  an  exact  statement  for 
each  kind  of  property,  claim,  and  liability.  The  pub- 
lication of  such  a  statement  with  the  balance  sheet 
gives  very  satisfactory  information  about  a  business. 
It  is  often  a  great  convenience  to  have  a  balance 
sheet  so  arranged  that  a  comparison  may  be  made  at 
a  glance  with  the  sheet  for  the  preceding  year.  The 
use  of  such  a  comparison  will  be  discussed  in  the 
next  chapter.  Sometimes  new  accounts  are  opened 
each  year  for  property  subject  to  constant  change. 
An  account  might  be  kept,  for  example,  to  contain 
additions  to  plant.  These  new  accounts  may  then 
be  reported  on  the  balance  sheet  as  distinctly  be- 
longing to  the  year  in  question,  and  may  then  be 
consolidated  with  the  old  accounts  as  they  stood  at 


THE  BALANCE  SHEET  329 

the  beginning  of  the  year.  This  arrangement  makes 
it  possible  for  one  to  see  at  a  glance  just  what  has 
happened  to  the  important  accounts  in  the  course  of 
the  year's  business.  The  result  is  produced  quite 
as  well,  however,  without  the  maintenance  of  sepa- 
rate accounts  in  the  ledger,  if  only  separate  columns 
are  provided  on  the  balance  sheet  to  indicate  in- 
creases and  decreases  for  the  year  just  passed. 

The  balance  sheet  shown  below  presents  all  the 
desirable  devices  suggested  in  this  chapter. 


330 


ACCOUNTI^^TG  AND  AUDITING 


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CHAPTER  XIV 

THE  INTEEPRETATION  OF  BALANCE  SHEETS 

Certain  information  can  be  had  from  a  balance 
sheet  standing  independent  of  all  other  figures,  but 
usually  we  are  concerned  in  studying  such  a  sheet 
to  learn  rather  what  is  the  course  of  things  than 
what  is  the  actual  present  situation.  Many  figures 
on  a  balance  sheet  show  an  outsider  very  little  about 
the  prosperity  of  the  business  as  a  whole;  for  many 
of  these  figures  come,  as  we  have  seen,  from  a  valua- 
tion put  upon  property,  and  unless  we  can  for  our- 
selves examine  that  property  we  are  not  in  a  posi- 
tion to  judge  as  to  the  correctness  of  the  sheet.  Tak- 
ing any  one  balance  sheet,  therefore,  we  are  obliged 
usually  to  assume  a  certain  degree  of  correctness  in 
the  figures,  and  the  correctness  which  we  assume 
will  be  determined  largely  by  our  judgment  of  the 
character  of  the  men  who  have  made  the  figures. 
When,  on  the  other  hand,  we  have  two  or  more  bal- 
ance sheets,  we  can  learn  from  them,  if  we  assume 
that  the  same  methods  are  employed  in  getting 
balances^  for  the  second  sheet  as  for  the  first,  what  is 
the  apparent  tendency  of  the  business.  We  can 
learn  from  such  a  comparison  of  balance  sheets,  for 
instance,  whether  the  amount  of  cash  is  increasing, 
whether  more  money  has  been  borrowed,  whether 

33X 


332  ACCOUNTING  AND  AUDITING 

more  property  has  be^n  invested  in  the  business, 
whether  larger  reserves  are  maintained  for  emer- 
gencies. Such  comparisons  are  usually  worth  mak- 
ing, for  they  enable  us  to  learn  what  sort  of  re- 
sources the  business  is  accumulating  and  what"  sort 
of  liabilities  it  is  incurring  or  satisfying.  For  some 
lines  of  business  the  best  sign  of  health  is  an  increase 
of  investment  in  permanent  property,  but  for  others 
it  is  an  increase  in  assets  readily  convertible  into 
cash. 

Let  us  examine  first  the  method  of  drawing  con- 
clusions about  the  general  tendencies  of  a  business, 
and  then  later  analyze  in  some  detail  the  different 
accounts  on  a  balance  sheet  and  see  what  light  they 
throw  on  solvency.  We  have  all  along  seen  the  neces- 
sity for  a  debit  whenever  there  is  a  credit,  and  vice 
versa.  It  must  be  true,  therefore,  that  for  every 
expenditure  some  resource  can  be  found,  and  that 
for  every  resource  utilized  some  destination  can  be 
found;  for  otherwise  we  should  have  some  unex- 
plained fact  on  the  books.  Only  three  kinds  of 
sources  are  available  from  which  expenditures  can 
be  made,  and  only  three  kinds  of  explanations  are 
possible  for  the  disappearance  of  resources.  The 
three  sources  from  which  expenditures  can  be  made 
are  earnings — ^which  do  not  appear  on  the  balance 
sheet  except  when  a  balance  has  been  left  over  after 
the  payment  of  dividends, — items  appearing  on  the 
balance  sheet  at  the  beginning  of  the  year,  and  new 
investment  of  capital  or  loans  during  the  year;  for 
since  the  operations  of  the  business  consist  in  turning 
over  its  property  so  that  profit  shall  be  earned,  notn- 
ing  has  been  available  to  spend  except  as  it  has 


INTERPRETATION  OF  BALANCE  SHEETS    333 

arisen  from  the  conversion  of  old  assets,  from  the 
use  of  new  property  entrusted  to  the  business,  or 
from  revenue.  Similarly,  the  three  possible  des- 
tinations of  expenditure  are  the  cost  of  conducting 
business,  the  payment  of  .liabilities  as  they  appeared 
on  the  balance  sheet  at  the  beginning  of  the  year, 
and  the  creation  of  new  assets.  Yet  all  six  of  these 
sorts  of  items — three  sorts  of  resource  and  three 
sorts  of  expenditure — ^have  effect  on  the  balance 
sheet;  for  four  of  them  are  exclusively  balance-sheet 
items,  and  the  revenue  and  expense  items,  if  they  do 
not  (with  the  dividends)  exactly  cancel,  must  go 
from  the  income  sheet  to  the  balance  sheet  as  sur- 
plus or  deficit.  So  a  comparison  of  balance  sheets 
for  two  years  will  show,  except  for  items  which 
cancel  each  other  (such  as  old  bills  receivable  paid 
and  new  ones  received,  or  earnings  paid  as  divi- 
dends), a  complete  statement  of  operations  for  the 
year.  If,  for  instance,  the  gross  profits  of  the  year 
have  been  $200,000,  the  expenses  $150,000,  and  the 
dividends  $25,000,  we  have  remaining  $25,000  of 
profits  which  ought  to  appear  now  not  only  as  addi- 
tional surplus  on  the  balance  sheet,  but  also  some- 
where among  the  net  assets — either  alone  or  produc- 
ing a  larger  balance  of  net  assets  than  were  shown 
a  year  ago.  Similarly,  if  our  liabilities  are  smaller  than 
a  year  ago,  we  have  not  fully  explained  the  trans- 
actions of  the  year  just  passed  unless  we  can  point 
to  the  sources  from  which  those  liabilities  were  liqui- 
dated. This  liquidation  may  have  come  from  surplus 
profits,  from  some  new  investments  of  capital,  or 
from  the  diversion  of  some  old  assets  to  the  annul- 
ment of  liability.    It  is  true,  of  course,  that  though 


334  ACCOUNTING  AND  AUDITING 

Bills  Receivable  at  the  beginning  of  the  year  may 
have  amounted  to  $50,000  and  still  remain  c.t  $50,000 
at  the  end  of  the  year,  our  transactions  in  Bills  Re- 
ceivable may  have  been  several  times  that  amount; 
but  this  is  not  a  matter  of  consequence  in  drawing 
conclusions  at  the  end  of  the  year,  for  assuming  the 
notes  to  be  equally  good,  our  situation  is  not  altered 
by  that  fact.  Such  a  comparison  of  balance  sheets 
does  not  show  the  magnitude  of  business  done;  it 
merely  shows  th^  ultimate  changes  resulting  from 
the  year's  operations.  Our  only  concern  is  the  de- 
creases and  increases  in  the  balance  of  each  account. 
The  conversion  of  merchandise  into  notes,  and  of 
those  notes  into  cash,  and  of  that  cash  into  more 
merchandise,  is  of  no  consequence,  except  so  far  as 
the  amount  of  merchandise  in  the  end  is  greater 
than  that  at  the  beginning,  or  so  far  as  a  profit  de- 
rived from  the  exchange  of  old  merchandise  for  new 
has  gone  into  some  other  account.  Let  us  now 
attempt  from  two  balance  sheets  to  learn  what  has 
gone  on  in  the  year  which  lies  between  them. 

It  is  usually  convenient  for  this  purpose  to 
arrange  decreases  and  increases  in  a  table  of  two 
columns.  The  first  column  may  well  be  headed 
*^ Resources  Utilized,"  and  the  second,  ^^Disposition 
of  Assets."  The  first  will  include  the  value  of  prop- 
erty which  the  business  has  converted  into  other 
forms,  the  amount  obtained  from  outside,  and  the 
amount  of  profits  which  have  remained  after  the 
payment  of  dividends — or  it  may  include  net  profits 
if  the  figure  of  dividends  is  entered  in  the  other 
column.  The  column  headed  *  *  Disposition  of  Assets ' ' 
will  include  the  value  of  all  property  procured  by 


INTERPRETATION  OF  BALANCE  SHEETS        335l 

utilizing  assets,  the  amount  of  debt  liquidated,  and 
the  amount  of  net  loss  or  deficit  if  the  business  has 
been  unprofitable.  It  must  be  noted  that  this  sheet 
for  indicating  operations  of  an  earning  period  is 
not  confined  to  dealings  with  the  outside  world,  but 
is  intended  quite  as  much  to  show  the  shiftings  of 
value  from  one  department  to  another  within  the 
business.  It  ought  to  show  in  summary  form  the 
explanation  of  every  change  that  has  been  made, — 
and  every  change  has  not  only  a  cause  but  an  effect. 
If,  for  instance,  the  cash  on  hand  at  the  end  of  the 
year  is  less  than  that  on  hand  at  the  beginning  of 
the  year,  it  is  obvious  that  the  business  has  utilized 
a  certain  part  of  this  asset,  and  the  amount  of  shrink- 
age should  appear  under  the  head  of  ^^  Resources 
Utilized."  (The  amount  of  cash  expended  was,  of 
course,  very  much  more  than  this,  but  since  the  cash 
balance  has  shrunk  by  only  this  sum,  the  other  items 
offset  one  another  and  do  not  need  to  be  explained 
here.)  Question  at  once  arises  as  to  what  became 
of  that  cash.  We  cannot,  as  a  matter  of  fact,  learn 
from  an  examination  of  the  balance  sheet  just  what 
this  particular  cash  was  devoted  to;  but  we  can  tell 
what  were  the  total  changes  in  assets  and  liabilities, 
and  we  know  that  the  total  amount  of  resources 
utilized  must  equal  the  total  amount  of  disposition 
of  assets.  We  do  not  attempt,  therefore,  to  label 
this  cash  as  devoted  to  any  particular  piu*pose;  but 
when  our  table  is  complete  we  shall  see  that  this  cash 
utilized,  plus  other  resources  utilized,  will  equal  the 
total  disposition  shown  by  the  other  column. 

We  may  now,  after  this  illustration  of  the  method 
to  be  applied  in  the  construction  of  such  a  sheet,  take 


336  ACCOUNTING  AND  AUDITING 

the  principal  items  one  by  one  and  see  how  they 
should  be  treated.  Let  us  use  for  practice  the  balance 
sheet  given  at  the  end  of  the  preceding  chapter  (page 
330) .  The  first  item  on  the  assets  side  is  Real  Estate. 
We  find  that  the  comparison  of  this  balance  sheet 
with  the  preceding  one  shows  an  increase  in  real 
estate  of  $2,000.  This  change  in  value  indicates  not 
Avhere  the  business  obtained  a  resource  to  use,  but 
what  it  did  with  some  resource  which  it  either  had 
at  the  beginning  of  the  year  or  received  during  the 
year.  It  explains  the  expenditure  of  money.  This 
$2,000  increase  in  real  estate,  then,  will  be  entered 
under  the  head  of  *' disposition  of  assets."  (See  page 
341.)  If,  on  the  other  hand,  the  valuation  of  real 
estate  had  shrunk  $2,000,  it  would  have  been  obvious 
that  this  shrinkage  should  appear  as  a  resource  util- 
ized; for  if  the  value  on  hand  at  the  end  of  the  vear 
is  not  so  much  as  it  was  at  the  beginning,  the  man- 
agers have  either  sold  real  estate  or  have  consumed 
it  in  the  conduct  of  the  business;  in  either  case  they 
should  have  other  assets  to  show  for  it — unless,  in- 
deed, the  business  has  suffered  loss,  and  even  this  is 
a  ** utilization  of  assets,"  though  the  unfortunate 
utilization  of  a  good  thing  to  produce  a  bad  one. 

The  increase  in  plant  and  machinery  measures 
also,  of  course,  a  disposition  of  assets,  for  the  busi- 
ness had  to  give  something  for  that  increase. 

The  decrease  in  investments  shows  that  these 
assets  were  utilized — ^that  $2,000  of  the  good  of  them 
has  been  exhausted.  The  amount  is  written  in  the 
column  headed  ** utilization  of  resources." 

Our  next  item  is  Bills  Eeceivable.  If  the  amount 
is  increased  at  the  end  of  the  year,  as  compared  with 


mTERPRETATION  OF  BALANCE  SHEETS        33? 

the  begiiming,  it  is  obvious  that  the  business  has 
accumulated  certain  property  in  this  form,  and 
although  this  is  now  a  resource,  it  is  not  a  resource 
which  has  'been  utilized  during  the  year  past;  on  the 
contrary,  some  other  resource  must  have  been  util- 
ized to  secure  for  us  such  an  increase  in  bills  receiv- 
able— such  as  a  sale  of  merchandise,  or  payment  in 
cash.  In  any  case  we  know  that  an  increase  in  bills 
receivable  has  cost  something,  and  since  an  increase 
explains  for  what  we  have  made  some  disposition  of 
assets,  the  amount  should  go  into  the  disposition 
column.  In  the  case  in  hand,  however.  Bills  Eeceiv- 
able  is  found  to  have  suffered  a  decrease;  so  it  is 
obvious  that  some  of  the  notes  on  hand  at  the  be- 
ginning of  the  year  either  have  been  paid  off,  and 
have  thus  brought  in  other  property,  or  have  been 
written  off  as  bad  debts.  Under  the  first  supposi- 
tion, this  decrease  explains  the  source  from  which 
other  property  has  been  obtained,  and  under  the 
second  it  explains  in  part  how  the  business  happened 
to  have  a  deficiency  at  the  end  of  the  year;  under 
either  supposition  the  decrease  indicates  a  utiliza- 
tion during  the  year  of  resources  existing  a  year  ago. 
We  write  it  in  the  first  column. 

The  account  for  customers  has  increased  $3,000; 
that  is,  customers  owe  more  than  they  did  a  year  ago. 
Clearly  they  do  not  owe  for  nothing:  the  business 
must  have  given  something  (merchandise,  of  course) 
for  this  asset.  The  increase,  therefore,  measures  the 
disposition  of  assets:  it  shows  what  has  become  of 
some  of  the  other  property  entrusted  to  the  business. 
The  amount  is  therefore  entered  in  the  second 
column.     If,  on  the  other  hand,  this  account  had 

A  &  A-22 


338  ACCOUNTING  AND  AUDITING 

shrunk,  it  would  have  showm  that  by  this  amount  the 
assets  in  the  business  a  year  ago  had  been  utilized 
in  this  year's  operations. 

Let  us  now,  with  these  first  cases  in  mind,  get  a 
comprehensive  view  of  the  theory  of  this  tabulation. 
Novices  at  this  sort  of  thing  are  usually  confused  at 
first  because  they  forget  what  they  are  seeking.  The 
purpose  of  this  classification  is  to  explain  things 
done  in  the  year  past.  We  cannot  from  such  a  table 
see  what  went  to  any  destination,  for  the  thing  is  no 
longer  connected  with  its  origin:  we  know  only 
where  value  is  today.  Prom  the  where,  today, 
we  wish  to  learn  changes  in  the  year  past, 
A  decrease  in  the  amount  of  an  asset  today  in 
comparison  with  that  of  a  year  ago  shows  that  some 
of  that  resource  has  been  utilized  in  the  year's  in- 
terval; an  increase  in  an  asset  shows  that  during  the 
year  past  some  other  asset  must  have  been  ex- 
changed for  this — i.  e.,  this  shows  a  disposition  of 
assets;  an  increase  in  liabilities  shows  that  a  resource 
was  utilized — for  the  business  used  its  borrowing 
capacity;  and  a  liability  discharged  shows  that  assets 
were  given  for  payment,  and  therefore  disposed  of. 

Our  next  item  is  Merchandise.  Since  this  shows 
a  larger  figure  than  at  the  beginning  of  the  year,  it 
is  obvious  that  the  present  inventory  is  larger  than 
the  old,  and  therefore  that  in  the  past  other  re- 
sources have  been  sacrificed  to  procure  this  present 
resource.  The  amount  of  increase  should  go,  then, 
into  the  column  headed  ^^disposition  of  assets,"  for 
it  explains  for  what  purpose  other  assets  were  dis- 
posed of.  If,  on  the  other  hand,  the  item  of  inventory 
showed  a  decrease,  it  would  indicate  that  goods  on 


li^TEBPRETATIOK-  OF  BALANCE  SHEETS        389 

hand  at  the  beginning  of  the  year  had  been  utilized; 
so  the  item  should  go  into  the  first  column. 

If  this  still  proves  puzzling  to  the  reader,  he  may 
find  himself  able  to  do  his  thinking  more  clearly  if 
he  changes  the  titles  of  his  columns.  If,  instead  of 
*^ utilization  of  resources,"  he  thinks  of  *' where 
got,"  he  may  see  that  a  shrinkage  of  inventory 
should  go  into  the  first  column ;  for  it  explains  where 
the  business  got  some  of  the  resources  that  it  util- 
ized. Similarly,  ^' where  gone"  may  be  substituted 
for  ' '  disposition  of  assets. ' '  Then  it  is  apparent  that 
an  increase  in  inventory  shows  a  ^* where  gone"  for 
the  year  past;  it  shows  what  has  become  of  some  of 
the  assets  entrusted  to  the  business.  So,  also,  in- 
creases of  liabilities  show  *^ where  got,"  and  de- 
creases show  *^ where  gone." 

Eeturning  now  to  our  balance  sheet,  we  see  that 
a  decrease  in  discounted  notes  indicates  cancellation, 
or  collections,  therefore  ^^ resources  utilized"  or 
*^ where  got."  Since,  however,  it  is  exactly  offset  by 
a  similar  contingent  item  on  the  other  side,  we  may 
as  well  omit  it  from  our  table. 

The  deficit  on  operation  is  clearly  a  *^  where 
gone.  "Indeed,  the  sole  purpose  of  the  deficit  account 
is  to  show  that  some  assets  have  disappeared, 
**gone,"  in  operation.  It  is  also  a  disposition  of 
assets,  for  the  business  consumed  assets  in  running  at 
a  loss. 

Let  us  turn  now  to  the  other  side  of  the  balance 
sheet.  The  first  changed  item  is  Bonds.  Since  this 
has  increased,  the  corporation  has  borrowed  money, 
and  a  resource  (borrowing  power)  has  been  utilized. 
So  the  item  is  written  in  the  ^^ where  got"  colunm. 


340  ACCOUNTING  AND  AUDlTIi^G 

If,  on  the  other  hand,  the  amount  of  outstanding 
bonds  had  decreased,  it  would  have  been  evident  that 
some  assets  had  been  devoted  to  this  use,  and  the 
amount  would  have  gone  into  the  second  column. 

The  increase  in  Bills  Payable,  similarly,  shows 
that  the  company  has  utilized  one  of  its  sources  of 
obtaining  property  from  outside,  and  the  amount 
should  appear  in  the  first  column.  If,  on  the  other 
hand,  the  amount  of  bills  payable  had  decreased,  it 
would  have  shown  that  the  company  had  paid  off  a 
certain  portion  of  these  debts,  and  since  it  could  not 
have  paid  them  off  without  the  giving  of  value,  this 
payment  would  have  explained  a  disposition  of 
assets,  and  the  amount  would  have  appeared  in  the 
second  column. 

The  decrease  in  the  account  for  creditors  shows 
that  debts  have  been  paid,  and  therefore  that  assets 
have  been  disposed  of.  The  amount  shows  *^  where 
gone." 

The  increase  in  accrued  interest  as  a  liability 
shows  that  the  business  has  had  the  use  of  money 
that  it  has  not  yet  paid  for,  and  it  should  have  assets 
to  correspond — or  the  interest  is  a  cause  of  the  loss 
on  operations,  that  is,  the  deficit.  This  increase 
shows,  therefore,  ^Svhere  got,"  or  utilization  of  re- 
sources.   It  is  entered  accordingly. 

If  an  operating  surplus  had  increased,  earnings 
must  have  been  in  excess  of  dividends,  and  conse- 
quently the  company  must  have  had  this  resource  as 
a  means  of  raising  necessary  funds.  The  amount 
would  have  been  extended,  therefore,  into  the  first 
column.  If,  on  the  other  hand,  surplus  had  been  de- 
creased, that  fact  would  have  meant  thaf  a  part  of 


INTERPRETATION  OF  BALANCE  SHEETS         341 

the  assets  had  been  disposed  of  in  the  payment  of 
dividends  or  repairs  or  some  other  operating  ex- 
igency, so  that  the  undistributed  profits  remaining 
would  have  been  smaller  than  at  the  beginning  of 
the  year,  and  the  amount  would  have  been  entered 
under  ^^  where  gone.^' 

When  all  changes  as  shown  by  the  comparison  of 
balance  sheets  have  been  entered  as  has  just  been 
indicated,  the  amounts  of  the  two  columns  should 
correspond  exactly;  for  not  more  disposition  can 
have  been  made  of  assets  than  has  been  warranted 
by  the  resources  utilized.  If  there  has  been  no  error 
in  calculation,  the  proof  will  be  exact  to  a  cent;  for 
everything  has  been  done  by  double  entry. 

SUMMAEY  OF  TRANSACTIONS  FOE  THE  YEAE 

UTILIZATION    OF    RESOURCES  DISPOSITION    OF   ASSETS 

Investments,  decrease  $  2,000     Eeal  estate,  increase  $  2,000 

Bills  receivable,  decrease  5,000     Plant  and  machinery,  increase    1,000 

Bonds,  increase  2,000     Customers,  increase  3,000 

Bills  payable,  increase  5,460     Merchandise,  increase  4,000 

Interest  accrued,  increase  40     Deficit,  increase  2,500 

Creditors,  decrease  2,000 


$14,500  $14,500 


The  real  purpose  of  this  statement  is  not  so  much 
to  get  figures  showing  the  changes  in  individual 
accounts  as  to  present  in  definite  form  a  summary 
which  shall  enable  one  to  judge  whether  the  prop- 
erty of  the  business  is  this  year  in  a  more  desirable 
shape  than  it  was  last  year.  If  current  liabilities 
have  increased  $20,000,  and  current  assets  have  de- 
creased $10,000,  the  situation  is  not  so  favorable  as 
it  was  a  year  ago,  unless  at  that  time  available  assets 


342  ACCOUNTING  AND  AUDITING 

were  lying  idle.  It  is  not  enough,  however,  to  know 
merely  that  total  cin*rent  assets  and  total  current 
liabilities  bear  an  improved  relation  to  each  other. 
If  a  year  ago  a  small  stock  of  goods  was  on  hand, 
and  this  year  a  large  stock  of  goods  is  accompanied 
by  a  limited  sum  in  cash,  the  business  is  not  in  quite 
such  good  shape  as  it  was  a  year  ago — unless,  in- 
deed, it  is  growing  faster  than  goods  can  be  secured 
and  an  increased  stock  is  necessary.  If  a  year  ago  it 
had  a  large  amount  of  cash  and  few  notes  and 
accounts  receivable,  but  this  year  has  a  small 
amount  of  cash  and  many  notes  and  accounts 
receivable,  the  appearance  is  unfavorable;  for  it 
seems  to  indicate  poor  collections.  One  must 
realize,  however,  that  a  large  increase  of  collectible 
items  may  come  from  a  large  increase  of  business  and 
may  accompany  a  shrinkage  of  cash;  for  the  same 
percentage  of  collections  would  show  an  increase  of 
unpaid  bills,  and  increased  purchases  may  explain 
the  decrease  in  cash.  If,  on  the  other  hand,  sales 
have  increased  only  ten  per  cent.,  but  bills  receivable 
and  accounts  receivable  have  increased  thirty  per 
cent.,  it  is  obvious  that  sales  are  made  to  a  class  of 
customers  less  able  or  less  willing  to  pay  bills 
promptly,  and,  therefore,  the  business  is  taking  the 
risk  of  heavy  loss  on  bad  debts.  Generally  speaking, 
merchandise  is  a  better  asset  than  such  debts; 
though,  of  course,  since  profit  is  made  generally  from 
the  sale  of  merchandise,  the  desirable  thing  is  to 
convert  merchandise  into  a  proper  number  of  good 
debts ;  but  an  increase  of  these  debts  out  of  relation 
to  the  amount  of  sales  and  to  the  amount  of  mer- 
chandise on  hand  is  an  indication  of  weakness.    If  a 


INTEEPRETATION  OF  BALANCE  SHEETS         343 

year  ago  the  business  had  a  small  investment  in  real 
estate,  plant  and  machinery,  with  few  bills  payable 
and  accounts  payable,  but  this  year  has  a  very  large 
investment  in  such  assets  and  many  bills  payable 
and  accounts  payable,  it  is  obvious  that  those  lia- 
bilities have  been  incurred  in  the  acquisition  of  those 
assets;  and  usually  this  would  be  an  unfavorable 
sign,  for  it  means  an  accumulation  of  liabilities  ma- 
turing soon,  and  only  fixed  assets,  which  might  not 
sell  readily,  as  a  means  of  payment.  If,  on  the  other 
hand,  it  were  known  that  money  could  be  borrowed 
at  any  time  on  long  terms,  through  the  issue  of 
bonds,  the  situation  would  not  be  dangerous.  It 
would  be  known  in  that  case  that  the  bills  payable 
and  accounts  payable  were  merely  temporary  and 
that  soon  the  balance  sheet  would  show  a  disappear- 
ance of  those  items  and  a  substitution  of  capital  lia- 
bilities in  the  form  of  funded  debt ;  and  a  funded  debt 
payable  in  the  futiu*e  is  naturally  invested  in  such 
permanent  things  as  real  estate,  plant  and  machin- 
ery. It  is  impossible  to  lay  down  any  hard  and  fast 
rules  in  regard  to  the  proper  tendency  of  items  in  a 
balance  sheet.  We  must  know  the  line  of  business 
before  we  can  say  whether  things  are  going  as  they 
ought  or  not;  but  it  is  always  desirable  in  passing 
judgment  on  the  solvency  of  a  business  to  make  such 
an  analysis  as  that  here  suggested  in  order  that  we 
may  have  at  a  glance  a  summary  explanation  of 
important  changes.  We  do  wish  to  know  why  this  or 
that  important  change  occurred  and  what  other 
items  were  affected. 

It  is  worth  while  to  dwell  upon  some  specific 
items  in  connection  with  the  balance  sheet  and  see 


344  ACCOUNTING  AND  AUDITING 

what  a  person  attempting  to  determine  solvency 
should  consider  in  relation  to  them.  Attention  has 
already  been  called  to  the  need  of  allowance  for  de- 
preciation in  connection  with  Real  Estate,  Plant  and 
Machinery,  Investments,  and  Merchandise.  Except 
for  Merchandise,  nothing  more  needs  to  be  said  about 
these  accounts.  As  was  suggested  in  the  chapter  on 
profit,  the  normal  price  of  merchandise  is  not  always 
the  billed  price,  but  that  price  less  the  largest  dis- 
count offered.  So  one  must  realize  in  considering  an 
inventory  that  the  basis  should  be  never  more  than 
the  net  price,  or,  if  the  goods  have  fallen  in  market 
value,  not  even  so  much  as  that.  It  is  well  for  any- 
one attempting  to  interpret  a  balance  sheet  to  note 
the  relation  between  the  present  inventory  of  mer- 
chandise and  that  of  other  years.  If  he  finds  that 
merchandise  valuation  is  constantly  increasing,  but 
sales  are  steady,  decreasing,  or  increasing  in  a  slower 
ratio  than  the  inventory,  he  has  reason  to  believe 
that  the  inventory  is  padded — either  deliberately, 
or  because  of  neglect  to  allow  for  unsalable  goods. 
If  a  manager  were  always  to  count  as  a  good  asset 
merchandise  purchased  long  ago,  and  never  recog- 
nize the  fact  that  certain  merchandise  has,  with  the 
lapse  of  time,  become  imsalable,  the  greater  his  store 
of  unsalable  goods,  the  bigger  his  merchandise  in- 
ventory. If  this  thing  were  to  go  on  for  a  series  of 
years,  it  might  be  found  in  the  end  that  an  inventory 
of  one  hundred  thousand  dollars  might  represent 
goods  which  on  the  market  were  worth  only  ten 
thousand  dollars. 

It   should  be   realized   always   that   both   bills 
receivable  and  the  accounts  of  customers  are  likely 


INTERPRETATION  OF  BALANCE  SHEETS   345 

to  prove  worth  less  than  the  book  value, — how  much 
less  will  depend  on  the  discretion  used  in  giving 
credits.  From  some  points  of  view,  bills  receivable 
are  preferable  to  book  accounts,  for  a  bill  receivable 
at  least  acknowledges  the  debt;  since,  however, 
under  some  conditions  goods  sold  and  not  paid  for, 
even  by  a  note,  may  be  replevined,  certain  book 
accounts  are  better  than  bills  receivable.  Judgment 
in  each  case  must  be  determined  by  circumstances. 
It  should  be  realized  also  that  customers'  accoimts 
are  likely  to  represent  claims  for  a  considerably 
smaller  sum  than  the  amount  recorded  on  the  books. 
If  discounts  are  allowed  for  early  payment  of  bills, 
the  customers'  accounts  are  subject  to  these  dis- 
counts and  only  if  none  of  the  discounts  offered  are 
accepted  will  the  claims  yield  their  full  face.  One 
must  always  realize,  therefore,  that  allowance  for 
discounts  is  as  important  as  allowance  for  bad 
debts.  This,  however,  is  not,  as  is  allowance  for  bad 
debts,  a  presumable  loss  to  the  business,  but  one  of 
its  bookkeeping  debits  due  to  the  fact  that  bills  have 
been  booked  at  more  than  the  natural  price. 

On  the  other  side  of  the  balance  sheet  only  one 
allowance  needs  to  be  made;  for  liabilities,  unlike 
resources,  are  bound  to  be  met  in  full  unless  the  busi- 
ness goes  into  bankruptcy.  The  single  exception  is 
discounts  offered  for  early  payments  to  creditors. 
If  the  discounts  presumably  to  be  taken  on  sums  due 
to  creditors  equal  the  discounts  presumably  to  be 
taken  by  customers,  the  items  do  not  need  to  appear 
on  the  balance  sheet — unless  to  show  that  they  have 
been  considered.  This  statement  is  not  incon- 
sistent  with   the   theory   of  discounts   previously 


346  ACCOUNTING  AND  AUDITING 

stated.  We  are  here  concerned  not  with  profits,  but 
with  assets  and  liabilities;  and  though  it  is  true  that 
discounts  neglected  by  our  customers  do  not  protect 
us  from  loss  on  discounts  which  we  neglect  (as  shown 
on  page  288),  discounts  to  be  taken  by  us  reduce  our  ' 
liabilities  in  the  same  degree  (dollar  for  dollar)  that 
discounts  to  be  taken  by  our  customers  reduce  our 
assets.  If  one  sort  of  discount  is  likely  to  be  larger 
than  the  other,  both  should  appear. 

It  is  well  in  this  connection,  though  the  items  do 
not  appear  on  the  balance  sheet,  to  compare  the 
amounts  of  discount  neglected  (or  the  amounts 
taken,  if  only  those  are  recorded)  for  the  last  year 
with  those  for  preceding  years  and  with  purchases 
and  sales.  It  is  evident  that  when  rates  of  discount 
offered  are  unchanged,  Collected  Discounts  decreas- 
ing (or  allowed  discounts  increasing)  on  goods  sold 
is  a  good  sign;  for  though  it  means  less  direct  profit 
from  this  source,  it  indicates  an  improvement  in  the 
general  business  standing  of  customers.  A  con- 
servative manager  would  rather  have  low  profits  on 
sales  to  sound  customers  than  larger  apparent  profits 
on  sales  to  questionable  customers.  Theoretically  no 
discounts  on  purchases  should  ever  be  neglected ;  but 
if  the  firm  is  poor  and  has  little  credit,  no  escape 
may  be  found.  In  such  a  case  Neglected  Discounts 
decreasing,  or  increasing  more  slowly  than  pur- 
chases, shows  an  improving  conditio 


CHAPTER  XV 

THE    DETEKMINATION    OF    COSTS 

All  our  discussion  up  to  this  point  has  been  based 
on  the  assumption  that  by  general  accounting  prin- 
ciples we  can  know  or  can  easily  calculate  the 
amount  of  debit  or  credit  to  any  account;  in  many 
cases,  however,  a  cost  is  so  well  mixed  with  other 
costs  that  elaborate  records  are  necessary  to  dis- 
tinguish which  portion  of  the  total  cost  belongs 
properly  to  one  item  and  which  to  the  others.  In 
manufacturing  it  is  not  usual  to  buy  raw  materials 
for  one  particular  product  and  to  put  labor  at  work 
in  producing  that  single  product;  it  is  customary  to 
purchase  supplies  in  large  quantities,  and  to  employ 
laborers  either  on  day  work  or  on  piece  work  so 
that  the  debit  to  Wages  is  to  be  divided  ultimately 
among  many  articles.  The  natural  entries,  there- 
fore, are  for  the  amount  of  material  consumed  and 
for  the  wages  involved  in  product  as  a  whole.  Though 
sometimes  distribution  to  separate  products  may  be 
made  by  a  mere  division  of  the  total  cost  among 
the  number  of  items  produced,  various  types  of 
articles  are  commonly  produced  under  conditions 
involving  di:ffering  amounts  of  raw  material  and  dif- 
fering amounts  for  wages,  and  for  each  of  these  care- 
ful record  must  be  kept  so  that  it  will  be  possible 
when  the  work  is  completed  to  know  what  has  been 

347 


348  ACCOUNTING  AND  AUDITING 

the  cost  of  that  product  both  for  raw  material  and 
for  labor.  These  two  elements  of  cost  are  commonly 
called  ^^ prime  cost,"  for  they  are  direct  and  involve 
no  complex  distribution  of  joint  cost  over  various 
articles.  Above  these,  however,  are  many  additional 
costs  which  cannot  be  found  individually  for  each 
item  of  product.  The  total  expense  for  insurance, 
rent,  repairs,  interest  on  capital,  and  various  items 
of  this  sort,  is  for  the  joint  benefit  of  many  products, 
and  must  be  distributed  at  some  time  over  the  total 
amount  of  product,  so  that  each  article  shall  bear  its 
share  of  the  total  cost  of  these  items.  If  these  last 
costs,  which  are  usually  called  *^ overhead  costs"  or 
*^ burden,"  are  not  distributed  over  the  total  product, 
or  at  least  if  the  prices  charged  for  the  product  do  not 
include  an  allowance  for  these  costs,  the  business  is 
necessarily  run  at  a  loss.  It  is  desirable  that  these 
overhead  costs  shall  be  charged  to  the  individual 
items  of  product  in  exactly  the  right  proportion,  for 
if  not  the  business  may  be  selling  some  goods  at  less 
than  their  actual  cost  to  manufacture.  This  suggests 
the  necessity  for  som^e  sort  of  cost  accounting  in  all 
manufacturing  and  other  lines  of  business  where 
many  items  of  product  or  service  are  rendered  at 
costs  which  do  not  readily  attach  themselves  to  each 
individual  item  of  result. 

The  purposes  of  cost  accounting  are  three:  (1)  to 
guide  the  managers  in  determining  what  is  the 
proper  price  to  be  put  on  each  article  of  product; 
(2)  to  enable  the  managers  to  learn  whether  an}'-  part 
of  their  product  is  more  or  less  profitable  than  other 
parts, — for  sometimes,  owing  to  peculiar  conditions, 
a  business  cannot  afford  to  make  certain  articles  at 


bETERMHSTATlON  OJ^  COSTS  f^ 

the  same  price  as  its  competitors,  and  had  therefore 
better  give  up  such  manufacture,  or  may  have  such 
advantage  over  competitors  in  some  articles  that  it 
may  well  concentrate  all  its  activities  on  these  alone; 
(3)  to  indicate  economies,  for  if  cost  accounting  is 
accurate  it  makes  possible  comparisons  between  one 
period  and  another  for  most  elements  in  the  manu- 
facturing process  and  shows  whether  the  maximum 
yield  is  obtained,  not  only  with  raw  material  con- 
sumed and  with  labor,  but  with  the  general  facilities 
which  cause  overhead  expense. 

The  importance  of  a  proper  distribution  of  over- 
head charges  may  be  best  illustrated,  perhaps,  by  a 
simple  case  of  manufacture  where  one  process  yields 
several  kinds  of  product.  If  we  are  to  know  not  only 
what  is  the  proper  price  to  make  on  our  goods,  but 
what  is  the  most  profitable  product,  and  what  is  the 
greatest  economy  of  expenditure,  we  must  know 
what  is  the  best  disposition  to  make  of  each  part  of 
the  joint  product.  In  a  saw-mill  one  stroke  of  the 
saw  produces  not  only  a  board,  but  a  slab,  or  an 
edging.  Taking  the  log  as  a  whole,  perhaps  a  dozen 
trips  of  the  saw-carriage  produce  several  boards,  two 
slabs,  and  many  edgings.  Under  some  conditions,  it 
may  be  cheaper  to  use  the  edgings  and  the  slabs  in 
the  engine-room  as  fuel  than  to  attempt  to  sell  them 
on  the  market.  In  such  a  case  the  only  salable 
product  is  boards.  If,  on  the  other  hand,  there  is  a 
good  market  for  edgings,  it  may  be  worth  while  to 
bundle  them  and  ship  them;  but  it  may  not  be  worth 
while  to  attempt  to  sell  the  slabs.  Finally,  it  may  be 
worth  while  to  sell  boards,  edgings,  and  slabs.  Be- 
fore one  can  tell  whether  one  should  sell  only  boards, 


360  ACCOtJNTING  A^B  AUDITING 

or  boards  and  edgings,  or  all  three  products,  one 
must  know  not  only  what  one  can  get  for  edgings 
and  slabs,  but  what  will  be  the  cost  of  getting  them 
on  the  market.  For  each  one  of  these  items  of 
product  there  is  one  cost  which  is  peculiar  to  it  and 
needs  to  be  met  only  in  case  that  product  is  to  be 
sold.  If,  for  instance,  edgings  and  slabs  are  to  be 
burned,  they  do  not  need  to  be  sorted  or  carefully 
piled  or  measured,  and  they  are  worth  something  as 
fuel.  They  will  go  directly  from  the  saw-table  into 
a  heap  from  which  they  will  be  passed  to  the  fire 
box.  To  sell  edgings,  however,  requires  at  least  the 
cost  of  sorting  them  from  the  slabs,  and  usually  of 
cutting  them  into  firewood  lengths  and  bundling 
them.  To  sell  the  slabs  requires  only  that  they  shall 
be  cut  into  firewood  lengths  and  separately  piled. 
Only  when  the  cost  of.  separating,  piling,  and  bun- 
dling is  known  can  the  manager  know  whether  he 
ought  to  sell  these  by-products  rather  than  consume 
them.  All  cost  accounting,  to  serve  its  purpose, 
then,  must  distinguish  as  far  as  possible  every  cost 
which  is  peculiar  to  any  product,  and  must  distin- 
guish the  return  from  each  kind  of  product;  then  a 
comparison  may  be  made  between  return  and  cost 
for  each  kind  of  product,  and  the  manager  can  learn 
not  only  the  absolute  but  the  comparative  profitable- 
ness of  that  enterprise, — that  is,  whether  he  had 
better  abandon  that  department  of  his  product  and 
concentrate  his  whole  energy  on  some  other  depart- 
ment that  yields  a  higher  profit. 

Let  us  turn  first  to  the  method  of  learning  prime 
costs — ^that  is,  costs  which  are  peculiar  to  any  one 
line  of  product  and  are  not  confused  with  a^y  joint 


Mteeminatiok-  of  cost^s  sSi 

elements.  The  common  practice  is  to  require  all 
work  done  in  a  shop  to  be  based  on  written  orders 
from  someone  in  authority.  As  soon  as  production 
is  ready  to  begin,  a  written  order  is  made  out  in  the 
central  office  to  indicate  what  materials  are  to  be 
used  in  its  production — or  at  least  what  materials 
are  to  be  turned  over  to  the  workman  for  his  use. 
Such  an  order  is  sent  to  the  storehouse,  and  when 
the  goods  are  issued  by  the  storekeeper  the  order  is 
receipted  by  the  workman.  On  the  return  of  the 
order  to  the  office,  the  books  can  show  exactly  what 
materials  have  been  issued,  and  after  allowance  has 
been  made  for  material  returned  to  the  storehouse, 
can  indicate  by  a  calculation  based  on  the  purchase 
price  of  the  goods  exactly  what  is  the  material  ele- 
ment in  the  cost  of  the  product.  Similarly,  for  all 
work  to  be  done,  an  order  is  issued  to  each  work- 
man, and  when  his  work  has  been  completed  that 
order  is  signed  by  the  foreman  accepting  the  work 
and  this  authorizes  the  payment  of  wages.  This 
signed  order  furnishes  information  to  the  office  as  to 
the  labor-cost  of  this  product. 

Let  us  now  examine  this  in  somewhat  more  de- 
tail. A  carefully  worked-out  scheme  of  accounting 
will  provide  that  all  stores  or  supplies  purchased 
shall  be  entered  in  a  stores  ledger,  so  arranged  that 
each  kind  of  article  kept  in  the  storeroom  has  an 
account  of  its  own,  which  may  be  debited  for  all 
stores  entering  the  storehouse  and  credited  for  all 
stores  issued.  The  storekeeper  is  held  responsible 
for  all  goods  which  he  receives,  and  must  give  a 
receipt  for  them,  and  he  receives  a  receipt  for  all 
goods  which  he  issues.    This  makes  it  possible  at  all 


S52  ACCOIJNTma  AND  AUDI*m(J 

times  to  know  what  stores  are  on  hand  and  to  pro- 
vide against  the  waste  of  material.  Each  general 
order  may,  of  course,  comprise  many  sub-orders,  or 
job  orders,  for  if  the  office  requires  a  case  of  shoes 
to  be  made,  sub-orders  are  needed  for  every  kind  of 
material,  such  as  sole  leather,  counters,  vamps, 
uppers,  etc.,  and  labor  orders  for  cutting,  stitching, 
finishing,  treeing,  etc.  The  labor  items  occurring  on 
job  order  slips  are  carried  not  only  to  the  cost  books, 
which  are  arranged  to  show  the  cost  of  each  order 
or  group  of  orders,  but  are  carried  also  to  the  time 
book  so  as  to  credit  each  workman  for  his  wages. 
The  cost  book  contains  a  separate  page  or  series  of 
pages  for  each  general  manufacturing  order,  and  all 
sub-orders  or  job  orders  (for  detailed  portions  of 
work  on  the  general  order)  are  entered  under  the 
proper  heads  so  that  when  a  job  is  completed  the 
total  cost  of  that  job,  both  for  material  and  for  labor, 
is  found  by  simple  addition.  This  may  serve,  roughly, 
as  an  outline  of  the  method  of  accounting  for  prime 
costs.  The  details  will  differ  largely  in  different 
factories  because  of  differing  conditions,  and  it  is 
impossible  in  a  book  of  this  general  type  to  cover 
the  subject  in  its  various  complex  forms. 

We  may  now  pass  to  the  general  subject  of  the 
distribution  of  burden,  or  overhead  cost.  It  is  ob- 
vious that  so  far  as  we  may  attach  all  overhead  costs 
to  a  single  element,  we  may  keep  the  accounting  sim- 
ple; if,  for  example,  we  should  find  that  all  overhead 
costs  bear  some  definite  relation  to  wages,  we  could 
distribute  those  overhead  costs  on  the  basis  of  the 
wages  expense  on  each  job.  This,  indeed,  is  a  com- 
mon method  of  distributing  burden.    It  has,  how- 


DETEEMIXATION  OF  COSTS  353 

ever,  one  fundamental  objection.  It  charges  as 
much  overhead  cost  to  a  job  requiring  $4  worth  of 
labor  employed  in  hand  cutting  of  uppers  in  a  shoe 
shop,  for  example,  as  to  one  employing  $4  worth  of 
labor  to  run  a  high  cost  machine  which  must  be 
insured  and  involves  taxes,  repairs,  depreciation, 
and  much  power-cost.  Such  distribution  of  burden 
is  obviously  unfair,  for  the  most  important  over- 
head costs  in  connection  with  the  cutting  of  uppers 
by  hand  are  those  connected  with  the  housing  of 
the  workman  and  his  material — that  is,  rent,  heat, 
light — and  the  administrative  costs  of  directing  his 
labor,  but  besides  these  the  machine  involves  in- 
terest, depreciation,  repairs,  insurance,  and  taxes. 
If  we  were  to  charge  goods  produced  by  hand 
labor  with  the  same  proportion  of  overhead  expense 
that  we  charge  to  goods  produced  largely  with  high- 
cost  machinery,  we  should  find  probably  that  we 
could  not  sell  our  hand-made  goods  at  the  market 
price,  and  that  the  demand  for  our  machine-made 
goods  would  be  very  heavy  because  of  the  low  price; 
and  yet  our  business  would  be  losing  money,  for  our 
distribution  of  costs  would  be  on  the  assumption 
that  the  hand-made  goods  would  bear  their  share  of 
the  overhead  costs,  and  since  those  hand-made  goods 
would  not  be  sold,  they  would  not  make  up  the  de- 
ficiency in  burden  borne  by  the  machine-made  goods. 
The  only  useful  accounting,  then,  is  to  see  that  the 
overhead  costs  are  borne  by  the  particular  product 
involved  in  their  use. 

Another  device  commonly  adopted  for  the  dis- 
tribution of  overhead  costs  is  a  proportion  based  not 
on  wages,  but  on  hours  of  labor.    This  is  obviously 

A  &  A-23 


354  ACCOUNTING  AND  AUDITING 

less  satisfactory  than  the  distribution  based  on 
wages;  for  it  would  carry  as  much  overhead  cost  to 
the  product  of  the  labor  of  a  boy  working  by  hand 
for  seventy-five  cents  a  day  as  it  would  carry  to 
the  product  of  the  labor  of  a  skilled  workman 
getting  six  dollars  a  day  and  working  with  a  very 
high-cost  machine.  This  is  in  reality  the  height  of 
absurdity,  and  unless  practically  all  work  is  done 
under  the  same  conditions,  both  of  wages  and  of  the 
utilization  of  expensive  equipment,  one  might  almost 
as  well  not  attempt  to  distribute  overhead  cost  at  all 
as  to  distribute  it  all  on  this  basis.  If,  however,  the 
benefit  of  any  particular  portion  of  burden  is  clearly 
shared  by  any  product  in  the  ratio  of  labor,  this  basis 
may  be  used  for  that  portion,  but  the  desirable  thing 
is  to  keep  as  low  as  possible  the  number  of  bases; 
then  the  accounting*  is  simple. 

The  scientific  method,  at  least  for  all  shops  where 
many  types  of  goods  are  produced  under  varying 
conditions,  is  to  take  into  account  the  several  ele- 
ments involved  in  the  production  of  every  article — 
and  this,  as  will  be  seen  later,  is  not  nearly  so  serious 
a  task  as  might  at  first  thought  appear, — and  group 
them  so  that  those  assignable  on  the  same  basis  may 
be  treated  in  a  lump  sum.  The  general  overhead 
costs  may  be  grouped  roughly  as  follows:  first,  ad- 
ministration and  superintendence, — that  is,  the  cost 
of  running  the  office  with  its  accounts  and  records, 
and  the  cost  of  directing  the  labor  into  proper  chan- 
nels so  that  the  maximum  product  is  got  with  the 
minimum  of  expenditure;  second,  the  costs  for  the 
buildings  which  house  the  workmen,  the  supplies, 
and  the  machines ;  third,  the  costs  connected  with  the 


DETEEMIXATIOX  OF  COSTS  355 

macliinery  itself;  and,  finally,  the  costs  of  power.  A 
large  portion  of  these  expenses,  it  will  be  noted, 
attach  themselves  directly  to  machinery,  for  the 
amount  of  space  required  is  determined  largely  by 
the  size  and  character  of  the  machinery,  the  amount 
of  interest  and  insurance  and  taxes  is  determined  by 
the  cost  of  the  machines  plus  the  cost  of  the  build- 
ings (which  can  be  distributed  in  large  part  on 
the  basis  of  machinery),  and  the  amount  of  power 
required  is  determined  directly  by  the  machinery. 
If,  then,  we  attach  these  items  to  machinery  and 
distribute  them  on  the  basis  of  each  machine's  pro- 
portion of  that  cost,  so  that  each  manufacturing 
order  will  be  debited  for  these  costs  on  the  basis  of 
its  use  of  the  machine,  we  shall  have  very  few  over- 
head costs  remaining  to  distribute  on  any  other  basis. 
Let  us  attempt,  therefore,  to  attach  as  many  of  these 
overhead  costs  as  we  may  to  the  machines  utilized  in 
manufacturing  processes. 

It  is  true,  of  course,  that  the  buildings  are  to 
protect  workmen  as  well  as  to  protect  machines,  but, 
where  the  work  is  done  by  machinery,  for  housing 
purposes  the  workman  and  the  machine  form  a  unit, 
and,  consequently,  we  may  simplify  our  task  by  con- 
sidering that  space  occupancy  is  a  machine  expense 
(allowing,  of  course,  room  enough  for  the  workmen 
to  get  about  and  utilize  the  machines).  Let  us  first, 
then,  find  all  the  costs  connected  with  space  and  dis- 
tribute it  to  the  machines  in  proportion  to  their 
space  occupancy.  The  first  cost  in  connection  with 
space  is  the  rent,  and  that  is  cost  to  the  manufactur- 
ing end  of  the  business,  even  though  the  building  is 
owned  by  the  proprietors;  for  they  as  owners  are 


356  ACCOUNTING  AND  AUDITING 

entitled  to  collect  rent  from  the  manufacturing 
processes  quite  as  much  as  if  the  building  were  leased 
to  outsiders.  If  the  product  does  not  compensate 
the  business  for  the  use  of  its  real  estate,  the  business 
is  not  profitable,  and  prices  must  be  fixed  at  such  a 
point  that  the  product  will  give  that  compensation. 
Starting,  then,  with  ground  rent,  we  add  interest  on 
the  cost  of  the  buildings,  depreciation  which  is  in- 
evitable with  the  lapse  of  time  (at  least,  on  the  build- 
ings themselves,  even  though  the  ground  rent  may 
be  actually  rising),  repairs  which  are  necessary  to 
keep  the  buildings  in  an  efficient  state,  insurance 
against  loss  by  fire,  and  taxes.  These  together  com- 
prise the  total  expense  to  the  business  for  protection 
against  exposure  of  its  machinery  and  of  the  men  to 
run  it;  and  this  expenditure  must  be  borne  by  the 
product  of  the  machines  in  proportion  to  the  amount 
of  space  required  by  these  machines.  If  any  ma- 
chine, then,  occupies  one  one-hundredth  of  the  total 
floor  space  of  the  shop,  its  share  of  floor-space  cost 
will  be  one  one-hundredth  of  the  total  figure  which 
we  have  just  obtained.  We  must  next  add  the  cost 
of  heating;  this,  however,  should  be  based  not  so 
much  on  floor  space  as  on  cubic  capacity.  Lighting, 
on  the  other  hand,  need  not  necessarily  be  on  the 
basis  of  space  at  all,  for  some  large  machines  may  be 
operated  with  very  little  lighting;  the  basis  here, 
therefore,  will  be  the  number  of  lights  required  for 
this  machine,  as  compared  with  the  total  number  of 
lights  required  for  all  machines. 

The  second  group  of  costs  attached  to  machinery 
comprises  those  connected  with  the  mere  possession 
of  the  machine  itself,  and  includes  interest  on  the 


DETERMINATION  OF  COSTS  357 

cost,  depreciation  due  to  obsolescence,  repairs  re- 
quired to  keep  it  in  condition,  insurance,  and  taxes. 
These  costs,  it  will  be  observed,  continue  even  though 
the  machine  is  not  in  actual  use ;  though  the  repairs 
included  here  comprise  only  the  slight  items  of 
periodic  care  to  protect  it  from  rust  and  dust. 

The  next  group  of  machine  costs  are  those  con- 
nected with  the  operation  of  a  machine  when  run- 
ning. These  include  the  consumption  of  oil,  waste, 
and  other  supplies,  depreciation  due  to  wear,  repairs 
necessitated  by  the  giving  out  of  small  parts,  and 
the  cost  of  the  small  tools  and  other  equipment 
attached  to  the  machine  for  its  manipulation.  The 
actual  cost  in  connection  with  these  tools,  however, 
is  not  the  original  cost  of  the  tools  themselves,  but 
simply  interest,  depreciation,  repairs,  insurance,  and 
taxes,  on  their  value.  The  last  item  in  this  group  is 
superintendence;  though  this  item  has  no  direct  con- 
nection with  the  cost  of  the  machine  itself  or  its 
operation,  we  are  endeavoring  to  attach  to  machinery 
as  many  as  possible  of  the  overhead  costs,  and  if 
several  machines  are  run  under  one  superintendent, 
and  they  require  equal  shares  of  his  care,  we  may 
well  distribute  his  wages  among  the  orders  on  the 
basis  of  their  use  of  machines.  If,  on  the  other 
hand,  various  machines  in  any  room  require  dif- 
ferent amounts  of  attention  from  him,  it  would  be 
difficult,  probably,  to  say  what  share  belongs  to  each, 
and  this  cost  of  superintendence  would  be  introduced 
elsewhere. 

The  last  group  is  the  costs  connected  with  power. 
These,  it  must  be  noted,  include  not  merely  the  cost 
of  fuel  and  of  employees  to  take  care  of  the  engine. 


358  ACCOUNTING  AND  AUDITING 

but  many  incidental  costs  connected  with  the  power 
establishment.  Among  these  would  be  the  space  of 
the  power  plant — either  for  the  portion  of  the  shop 
occupied  by  the  engine  room,  or  the  space  cost  of  a 
separate  building.  If  there  is  a  separate  building, 
the  five  elements  which  we  have  previously  seen  in 
other  connections  (interest,  depreciation,  repairs, 
insurance,  and  taxes)  must  be  figured  on  the  whole 
power  establishment.  Next  we  have  the  same  five 
elements  on  the  power  plant  itself,  that  is,  the 
boilers,  engines,  etc.,  including  shafting,  belting, 
pulleys,  and  other  transmission  elements  not  already 
included  elsewhere.  Finally,  we  should  have,  be- 
sides the  fuel  and  the  wages  of  engineer  and  fireman, 
costs  for  water,  oil,  waste,  etc.  When  we  have  deter- 
mined the  full  power  cost  of  the  whole  establish- 
ment, the  amount  chargeable  to  each  machine  is  de- 
termined by  the  ratio  of  its  horse-power  consump- 
tion to  the  total  horse-power  consumption  of  the 
establishment. 

If  we  now  add  all  these  costs  together — that  is, 
the  four  groups  of  space  cost,  machine  cost,  use  cost, 
and  power  cost — we  have  the  total  running  cost  per 
year  for  our  machine.  If  this  is  now  divided  by  the 
number  of  working  hours  in  a  year — making  allow- 
ance, of  course,  for  the  fact  that  no  machine  can  run 
all  the  time,  but  suffers  some  loss  of  time  because 
of  the  need  of  repairs,  cleaning,  etc., — we  shall  have 
what  is  commonly  called  the  '* machine  hour  rate." 
It  is  obvious  that  every  job  requiring  the  use  of  any 
machine  for  one  hour  is  costing  more  than  its  prime 
cost  (cost  of  material  and  labor)  by  the  amount  of 
this  machine  hour  rate,  for  the  total  cost  of  the  ma- 


DETERMINATION  OF  COSTS  359 

chine  for  the  year  divided  by  the  number  of  working 
hours  has  given  us  this  hour  cost  for  that  machine. 
The  accounting  for  this  additional  cost  to  each  order 
based  on  this  utilization  of  machinery  is  very  simple, 
for  if  on  all  order  slips  sent  in  by  workmen  an  entry 
is  made  showing  the  number  of  the  machine  and  the 
nmnber  of  hours  it  was  utilized,  the  office  can  readily 
enter  on  the  cost  book  the  overhead  charge  which 
should  be  added  to  the  prime  cost ;  this  is  found  by 
multiplying  the  hour  rate  by  the  number  of  hours. 
We  have  now  distributed  a  large  portion  of  the 
total  overhead  cost.  We  have  remaining  chiefly  the 
items  of  administration,  superintendence,  some  addi- 
tional costs  connected  with  stores,  and  space-cost  for 
parts  of  the  factory  which  do  not  utilize  machinery. 
So  far  as  in  any  part  of  the  shop  all  work  is  done  by 
hand,  space-cost  for  that  portion  may  be  distrib- 
uted on  the  basis  of  labor-time,  for  a  man  working  at 
six  dollars  a  day  takes  as  much  space,  heat,  and  light, 
usually,  as  a  boy  working  at  seventy-five  cents  a  day. 
The  full  remaining  space-cost  of  the  establishment 
may  be  provided  for  if  the  space  occupied  by  stores, 
by  superintendence,  and  by  the  administration,  is 
charged  to  each  of  these  departments.  Stores  must 
be  charged  for  freight  and  cartage,  and  for  interest, 
depreciation,  taxes  and  insurance  on  average  stores 
kept  in  stock;  the  total  gives  an  additional  sum 
which,  when  converted  into  a  percentage,  may  be 
added  for  each  order  to  the  amount  already  charged 
for  stores.  Then  the  administration  expenses,  in- 
cluding a  share  of  space  cost,  may  be  distributed 
over  all  the  product  on  the  basis  of  a  fixed  propor- 
tion of  administrative  costs  to  other  costs.    If  in  the 


360  ACCOUNTING  AND  AUDITING 

experience  of  this  shop  it  is  found  that  of  the  total 
manufacturing  costs,  including  not  only  prime  cost 
and  overhead  cost  but  administration,  ninety  per 
cent,  is  for  combined  prime  cost  and  burden,  and  ten 
per  cent,  for  administration,  to  each  order  one-ninth 
of  the  cost  shown  on  the  cost  book  for  items  already 
figured  should  be  added  for  administration.  This 
process  will  absorb  all  the  joint  or  overhead  cost  for 
the  factory  and  leave  each  order  charged  with  ap- 
proximately its  proper  proportion — that  is,  as  nearly 
so  as  it  is  possible  for  any  estimates  and  calculations 
to  provide. 

It  should  be  noted  that,  though  a  good  deal  of 
this  sounds  like  mere  estimating,  most  of  it  is  based 
on  known  facts.  We  do  not,  for  instance,  know  what 
is  the  actual  depreciation  of  any  machine  in  any 
period,  but  that  is  a  thing  which  can  never  be  known 
under  any  circumstances,  and  yet  some  provision 
must  be  made;  we  do  not  know  what  will  be  the 
actual  annual  cost  for  repairs,  but  we  do  know  after 
a  business  has  been  running  a  few  years  what  is  the 
actual  cost  for  rejiairs  as  an  average,  and  we  have  no 
reason  to  suppose  that  the  amount  will  be  particu- 
larly higher  or  lower  during  any  period;  we  cannot 
know  what  is  the  actual  coal  consumption  during  the 
hours  any  particular  job  is  on  a  machine,  but  we  do 
know  from  past  experience  what  is  the  normal  ratio 
of  fuel  to  power,  and  may  use  that  with  sufficient 
accuracy  for  the  present  purpose;  we  do  not  know 
what  is  the  actual  administrative  cost  while  this 
order  is  going  through  the  shop,  but  if  we  know  what 
has  been  in  the  past  the  ratio  of  administrative  cost 
to   manufacturing    cost,    we    may,   unless   notable 


DETERMINATION  OF  COSTS  361 

changes  have  occurred,  use  that  ratio  with  a  pretty 
close  approximation  to  truth  for  any  particular 
period.  Of  course,  since  the  purpose  of  careful  cost 
accounting  is  to  eliminate  as  much  as  possible  all 
waste,  it  is  constantly  hoped  that  the  costs  this  year 
will  in  all  particulars  be  lower  than  in  previous 
years,  and,  therefore,  it  is  usually  safe  to  use  as  a 
basis  the  figures  for  earlier  years,  for  the  present 
year's  variation  is  likely  to  be  on  the  safe  side.  All 
the  bases  may  be  revised,  moreover,  as  often  as  the 
managers  think  worth  while;  and  the  accounting  fur- 
nishes information  for  the  revisions. 

The  preceding  discussion  does  not  attempt  to 
cover  all  the  desirable  distributions  of  overhead 
costs,  of  course,  for  the  subject  is  so  full  of  detail 
that  nothing  less  than  a  large  volume  would  cover 
all  the  points  which  might  arise  even  in  one  factory. 
Nothing  is  attempted  here  more  than  a  general  out- 
line of  the  plai-.  Many  employers  scofif  at  such  a 
system,  for  they  say  that,  since  a  large  part  of  this 
determination  of  costs  is  at  best  only  an  estimate,  it 
is  well  enough  to  let  it  all  go  as  an  estimate  and 
satisfy  oneself  with  the  absolute  results  which,  at 
the  end  of  the  year,  show  only  whether  one  has  made 
a  profit  or  a  loss.  The  best  answer  to  that  criticism 
is  the  fact  that  in  many  large  shops  the  kind  of  plan 
outlined  above  is  actually  ^practiced,  and  has  been 
practiced  for  many  years,  and  that  the  managers  are 
satisfied  that,  though  the  cost  of  accounting  in  such 
detail  is  heavy,"  it  is  far  more  than  offset  by  the 
greater  precision  in  making  prices,  in  directing  the 
manager  as  to  w^hat  particular  lines  of  work  he  had 
best  push,  and  in  preventing  waste.    It  is  true  also 


363  ACCOUNTING  AND  AUDITING 

that  in  many  establishments  cost  accounting  systems 
have  been  attempted  with  great  detail,  and  have  been 
thrown  out  by  the  managers  after  a  short  trial  be- 
cause apparently  not  profitable;  but  in  many  such 
cases  it  has  been  found  on  investigation  that  the 
system  was  not  scientifically  devised  in  the  first 
place,  and  that  the  men  left  in  charge,  having  no 
sympathy  with  it,  made  no  effort  to  give  it  a  fair 
trial,  or  were  incompetent  to  carry  out  the  scheme 
with  anything  approaching  good  judgment. 

It  should  be  noted  that  although  the  original  cal- 
culations necessary  to  apportion  overhead  costs  on 
the  plan  outlined  above  are  laborious,  when  they 
have  once  been  carried  out  the  system  is  more  or  less 
automatic.  When,  for  instance,  the  space  cost  of 
the  whole  establishment  has  been  found,  it  does  not 
need  to  be  found  again  until  some  change  has  arisen 
in  the  conditions;  and  the  space  cost  for  each  par- 
ticular machine  is  simply  a  certain  proportion  of  the 
whole.  Similarly,  when  the  total  power  cost  for  the 
establishment  has  been  found,  that  total  is  used  for 
all  machines  by  a  simple  calculation  of  proportion. 

One  circumstance  is  not  provided  for  in  the 
scheme  outlined  above.  Our  calculation  has  been 
based  on  the  assumption  that  all  machines  are  run 
full  time.  In  many  shops  certain  equipment  is  neces- 
sary in  spite  of  the  fact  that  it  is  in  demand  only  a 
few  hours  a  day.  Obviously  some  provision  must  be 
made  for  that  sort  of  thing,  for  if  overhead  charges 
are  distributed  on  the  basis  of  full  time  for  all  ma- 
chines, and  then  some  machines  are  part  of  the  time 
idle,  the  product  will  not  absorb  all  the  overhead 
costs  at  the  end  of  the  year.    It  is  desirable,  there- 


DETERMINATIOiSr  OF  COSTS  363 

fore,  to  keep  a  record  of  the  actual  running  time  of 
each  machine,  and  then  in  calculating  the  charges 
to  recognize  the  fact  that  the  orders  utilizing  that 
machine  must  pay  for  the  idle  time.  This  is  a  prin- 
ciple recognized  practically  everywhere.  Proprietors 
of  public  halls,  for  instance,  do  not  determine  their 
charge  for  an  evening  on  the  basis  of  three  or  four 
horn's  out  of  a  possible  8,760  hours  per  year;  for  such 
a  hall  is  used  commonly  only  two  or  three  hundred 
times  a  year;  if  those  who  use  it  do  not  pay  their 
proportion  of  this  idle  time,  the  proprietors  do  not 
receive  adequate  compensation  for  the  use  of  their 
capital  and  sufficient  in  addition  to  cover  deprecia- 
tion and  other  expenses. 

In  connection  with  idle  time  we  find  that  careful 
record  is  demanded  by  the  same  three  considera- 
tions that  make  any  cost  accounting  imperative.  Only 
when  idle  time  is  known  can  prices  be  fixed  properly 
as  between  various  articles  of  product ;  only  then  can 
one  learn  how  to  provide  for  the  elimination  of  waste 
in  the  extremely  important  matter  of  the  utilization 
of  equipment ;  only  then  can  one  know  whether  it  is 
more  profitable  to  do  all  parts  of  manufacturing 
work  in  one's  own  shop  or  to  send  out  a  part  of  the 
work  to  be  done  elsewhere — or  even  to  abandon  some 
kinds  of  work  entirely. 

The  determination  of  prices  is  likely  to  be  affected 
differently  according  to  the  circumstances  under 
which  the  idle  time  is  suffered.  If  the  shop  is  in 
competition  with  other  shops  much  larger  or  turning 
out  such  a  kind  of  product  that  all  their  machinery 
is  used  for  full  time,  it  cannot  compete  in  low  prices 
unless  allowance  is  made  for  the  part-time  use  of  its 


364  ACCOUNTING  AND  AUDITING 

machines  and  the  loss  is  taken  out  of  profits.  This 
may  be  illustrated  roughly  by  supposing  that  in  the 
shop  in  question,  since  some  drilling  is  now  and  then 
necessary,  a  drill  must  be  maintained  in  constant 
running  order,  but  since  the  amount  of  drilling  is 
comparatively  small,  one  drill  working  a  quarter  of 
the  time  can  do  all  the  work.  If  this  shop  is  in  com- 
petition with  another  which  has  a  large  patronage, 
so  large  that  the  work  turned  out  by  the  other  ma- 
chines requires  enough  drilling  to  keep  one  drill  con- 
stantly occupied,  the  prices  prevailing  in  that  com- 
munity are  determined  by  the  shop  running  its  drill 
full  time;  and  the  shop  having  only  partial  use  for 
its  drill  must,  if  competition  is  keen,  take  the  loss 
for  idle  time  out  of  its  profits.  If,  on  the  other  hand, 
the  work  in  this  community  requiring  drilling  is 
small,  so  small  that  one  drill  can  do  all  the  work  for 
the  community  in  a  quarter  of  its  time,  the  minimum 
demand  of  the  community  requires  the  maintenance 
of  a  drill,  and  that  cost  may  be  charged  to  the  com- 
munity in  the  prices  set  on  the  work  done  in  that 
shop.  Even  if  it  were  known  that  no  competition  is 
to  be  suffered,  and  that  prices  can  be  made  always  to 
include  the  cost  of  idle  time  for  work  requiring  any 
drilling,  it  would  still  be  worth  while  to  keep  sepa- 
rate record  of  the  actual  amount  of  idle  time  on  that 
machine;  for  only  so  would  the  manager  know 
whether  conditions  were  improving  with  regard  to 
the  use  of  that  machine  or  not ;  and  only  so  would  he 
know  whether  his  estimate  for  idle  time  used  in  cal- 
culations for  the  work  of  this  year  needed  revision 
in  making  his  calculations  for  a  subsequent  year. 


DETERMINATION  OF  COSTS  365 

It  is  desirable,  therefore,  that  for  each  machine  a 
record  shall  show  the  work  done  each  year. 

The  burden  to  be  borne  by  any  order  in  connec- 
tion with  the  utilization  of  machinery  is  not  neces- 
sarily the  same  for  all  hours,  even  though  there  be 
no  idle  time.  Some  work  requires  a  considerable 
Xjreparation  of  the  machine,  such  as  adjustments  and 
fitting  special  tools.  Obviously,  the  cost  for  two 
hours  spent  in  adjusting  a  machine  to  a  job  is  less 
than  for  two  hours'  actual  work  on  that  job;  for  the 
two  hours  of  preparation  involve  only  two  of  the 
four  groups  of  cost  discussed  in  an  earlier  paragraph, 
— that  is,  space  cost  and  machine  cost.  The  cost  is 
as  great  for  space,  heat,  light,  insurance,  taxes,  in- 
terest, and  obsolescence,  for  two  hours  setting  up  a 
machine  as  for  two  hours  while  the  machine  is  run- 
ning; but  of  machine-use  cost  and  power  cost,  set- 
ting-up involves  nothing.  It  is  necessary,  therefore, 
in  order  to  make  complete  records,  to  distinguish  be- 
tween what  may  be  called  ^^ occupied  time"  and 
*^ running  time."  What  we  have  heretofore  treated 
as  one  machine  rate  may  well  be  split  into  two  rates. 
If  we  add  together  the  space  cost  and  the  machine 
cost  for  a  year  for  any  machine  and  divide  by  the 
number  of  working  hours,  we  get  what  may  be  called 
a  *' minimum  rate," — that  is,  what  it  costs  the  shop 
each  hour  to  maintain  that  machine  ready  for  use, 
whether  running  or  not.  If  we  add  together  the 
machine-use  cost  and  the  power  cost — that  is,  the  sec- 
ond and  third  groups  of  costs  connected  with  each 
machine — and  divide  by  the  number  of  working  hours 
in  the  year,  we  get  what  may  be  called  an  *^  addi- 
tional rate," — that  is,  what  must  be  charged  to  each 


366  ACCOUNTING  AND  AUDITING 

order  for  the  actual  extra  cost  of  running  the 
machine.  If  a  machine  were  occupied  all  the  time, 
the  charge  to  each  order  would  be  merely  the  mini- 
mum rate  multiplied  by  the  number  of  hours  the  job 
was  at  the  machine,  plus  the  additional  rate  multi- 
plied by  the  number  of  hours  the  machine  was  actu- 
ally running  at  that  job.  The  same  result  would  be 
obtained,  of  course,  if  w^e  were  to  multiply  the  run- 
ning hours  by  the  sum  of  the  additional  rate  and  the 
minimum  rate,  and  were  to  add  to  this  the  minimum 
rate  multiplied  by  the  number  of  hom's  the  job  was 
occupying  the  machine  in  preparation. 

The  moment  we  introduce  idle  time,  however,  we 
realize  that  each  job  must  bear  its  proportion  of  all 
the  necessary  idle  time  on  machines  required  by  that 
job.  If  a  machine  is  normally  running  but  half  time, 
just  as  a  public  hall  may  be  occupied  but  half  time, 
the  jobs  requiring  the  use  of  that  machine  must  pay 
for  twice  the  number  of  hours  actually  engaging  the 
machine, — else  the  full  space  cost  and  machine  cost 
of  the  machine  will  not  be  compensated  by  its 
product.  It  is  clear,  however,  that  for  idle  time  we 
need  figure  only  what  we  have  called  the  *^  minimum 
rate,"  for  no  machine-use  cost  or  power  cost  is 
incurred  by  idle  machinery.  To  get  the  desired  fig- 
ures we  have  only  to  require  that  on  the  order  slip 
or  time  slip  handed  in  by  each  workman,  and  show- 
ing what  machine  he  used,  he  shall  show  for  how 
much  of  that  time  the  machine  was  actually  running. 
In  the  accounting  department  the  occupied  time  is 
multiplied  by  the  minimum  rate,  and  the  running 
time  by  the  additional  rate.  The  total  is  the  earnings 
of  that  machine  for  that  specified  time,  and  is  the 


DETEEMINATION  OF  COSTS  36f 

correct  charge  to  that  order  on  this  score.  If,  how- 
ever, this  machine,  taking  the  year  through,  is  occu- 
pied half  time,  the  order  should  be  charged  an  addi- 
tional sum  equal  to  the  minimum  rate  charged;  for 
this  order  must  pay  its  sharq  of  idle  time,  which,  in 
this  case,  is  just  the  same  as  the  occupied  time.  If 
the  machine  is  occupied  three-fourths  of  the  time, 
the  charge  to  the  order  for  idle  time  is  one-third  the 
charge  for  minimum  rates  (for  since  one-third  as 
much  time  is  idle  as  is  occupied,  one-third  must  be 
added  to  absorb  the  full  cost  of  maintaining  the  ma- 
chine). These  amounts  are  added  on  the  cost  book 
to  the  other  costs  as  shown  from  other  sources — that 
is,  the  prime  costs  of  material  and  stores,  and  the 
other  elements  of  burden  comprising  administrative 
costs,  secondary  stores  costs,  administration,  etc. 
The  result  is  the  total  manufacturing  cost  for  that 
article. 

The  figures  of  the  order  slips  handed  in  by 
workmen  must  be  carried  also  to  another  record. 
Since  it  is  desirable  to  know  the  actual  accomplish- 
ment of  every  machine,  a  ledger  is  commonly  kept 
for  accounts  with  all  machines.  On  this  ledger 
are  entered  the  occupied  hours,  the  running  hours, 
and  the  idle  time.  In  this  case,  however,  the  idle 
time  will  not  be  an  estimate  but  the  actual  idleness. 
It  will  be  the  diference  between  the  occupied  hours 
and  the  possible  hours.  As  a  matter  of  fact,  how- 
ever, the  actual  idleness  does  not  need  to  be  com- 
puted each  day,  for,  of  course,  the  number  of  occu- 
pied hours  at  the  end  of  any  month  subtracted  from 
the  total  number  of  shop  hours  will  give  the  idle 
hours;  and  hence  this  item  need  be  entered  only  ai 


368  ACCOUNTING  AND  AUDITING 

convenient  intervals.  At  the  end  of  the  year  this 
machine  ledger  account  makes  it  possible  to  learn 
whether  the  estimate  of  idleness  was  erroneous, 
whether  conditions  within  the  shop  have  improved 
so  far  as  to  prove  good  management,  w^hether  it  is 
desirable  that  the  machine  shall  be  abandoned  and 
its  work  done  elsewhere. 

We  have  now  completed  our  study  of  manufactur- 
ing costs.  Many  items  besides  those  suggested  here 
may  prove  in  any  particular  factory  to  be  necessary 
in  a  cost  calculation.  It  is  impossible  to  construct 
any  scheme  which  shall  fit  all  factories.  All  we  can 
do  here  is  to  consider  the  principles. 

In  the  main,  the  method  of  distributing  selling 
costs  is  similar  to  that  for  distributing  the  burden 
in  manufacturing.  An  obvious  element  of  burden 
in  selling  is  space  cost.  This  will  be  determined  by 
the  same  method  as  for  manufacturing  costs — that 
is,  chargeable  to  the  selling  department  is  a  certain 
proportion  of  the  total  space  occupied  by  the  estab- 
lishment, of  interest  on  the  investment  in  buildings, 
of  insurance,  of  taxes,  of  depreciation  and  repairs 
on  buildings,  of  lighting,  and  of  heating.  A  certain 
part  of  the  general  administrative  expense  of  the 
business  must  be  borne  by  the  selling  department. 
The  wages  of  persons  employed  exclusively  in  that 
department,  with  advertising  costs,  costs  of  station- 
ery, postage,  commissions,  traveling  expenses,  etc., 
can  be  known  directly  and  should  be  charged  to  that 
department.  Most  selling  costs  are  capable  of  deter- 
mination by  percentages,  and  if  it  is  found  that  nor- 
mally selling  cost  is  fifteen  per  cent,  of  manufactur- 
ing cost,  that  percentage  should  be  added  to  the  cost 


DETERMINATION  OF  COSTS  36d 

of  each  order — unless  peculiar  circumstances  in  con- 
nection with  that  order  require  a  larger  siun  or  show 
that  the  order  should  be  relieved  of  a  portion  of  the 
general  charge.  If,  for  instance,  a  special  advertis- 
ing campaign  has  been  conducted  for  a  single  article, 
most  of  the  cost  of  that  campaign  should  be  charged 
to  the  sales  of  that  article — ^but  not  necessarily  all 
of  it,  for  the  general  reputation  of  the  firm  may 
have  been  improved  so  much  that  other  articles  share 
in  the  benefit.  So  far  as  any  work  is  done  for  the 
use  of  the  shop  itself,  and,  therefore,  involves  no 
selling  expense,  the  cost  should  be  deducted  from 
manufacturing  costs  before  the  percentage  for  sell- 
ing expenses  is  figured. 

Since  it  is  convenient  to  have  a  reference  list  of 
costs  for  all  articles,  it  is  well  to  have  for  each  article 
of  product  a  book  or  a  series  of  cards  which  shall  con- 
tain a  summary  of  all  costs  as  shown  by^past  experi- 
ence. This  would  show,  normally,  in  summary  form, 
something  like  the  following  table : 

stores  (from  order  slips)  $  6.27 

Stores  costs  (percentage  of  above)  .12 

Wages  (from  order  slips)  3.27 

Superintendence  (percentage  of  above)  .24 

Minimum  rates  (from  order  slips)  .33 

Idle  time  (ratio  to  above)  .66 

Additional  rates  (from  order  slips)  .85 

Department  and  general  expenses  (percentage  of  total  above)  .50 


Total  producing  cost  12.24 

Selling  cost  special  ,30 

Selling  cost  general  (percentage  of  producing  cost)  1.22 

Total  cost  13.76 

This  all  sounds  very  complicated,  but  the  book- 
keeping is  comparatively  simple,  though,  of  course, 
a  good  deal  of  labor  is  required  in  handling  the  de- 

A   &  A-24 


370  ACCOUNTING  AND  AIJBITING 

tails.  We  saw  that  the  first  element  of  burden  is 
space  cost.  If  a  ledger  account  is  kept  for  space 
cost,  it  is  a  simple  matter  at  the  close  of  the  year  to 
transfer  to  that  account  all  expenses  which  have 
gone  to  make  up  that  space  cost,  such,  for  instance, 
as  rent,  lighting,  heating,  building  repairs,  deprecia- 
tion, taxes,  and  insurance,  so  far  as  those  items 
relate  to  buildings  and  ground  space  occupied.  Then 
Space  Cost  may  be  credited  by  the  distribution  of 
this  total  to  accounts  representing  the  various  de- 
partments of  the  business  concerned,  such  as  Stores, 
Minimum  Rates  (which  is  ultimately  to  be  closed 
into  Manufacturing),  Administration,  Power,  and 
Selling.  These  credits  to  Space  Cost  will  always 
absorb  the  debits  and  leave  Space  Cost  with  no  bal- 
ance. Similarly,  to  Minimum  Rates  should  be 
charged  the  elements  connected  with  the  cost  of  ma- 
chinery (interest,  insurance,  taxes,  depreciation, 
possibly  superintendence),  and  its  share  of  space 
cost,  as  already  indicated.  These  debits  to  Minimum 
Rates  will  then  be  offset  in  part  by  a  credit  to  Idle 
Time;  for  since  we  have  charged  Minimum  Rates 
with  the  total  costs  of  burden  connected  with  the 
equipment  of  machinery,  and  Idle  Time  is  respon- 
sible for  a  part  of  that  cost,  it  should  relieve  Mini- 
mum Rates  of  a  part  of  that  burden,  and  should 
be  debited  for  the  actual  cost  of  idleness  as  shown 
by  the  machine  ledger  (number  of  hours  idleness  for 
each  machine  multiplied  by  the  minumum  rate  for 
that  machine).  Since  Idle  Time  is  thus  debited,  by 
Minimum  Rates,  for  its  share  of  space  cost  and 
machine  cost,  it  must  also  be  credited  for  the  amount 
charged  to  orders — that  is,  by  a  credit  to  Manufac- 


BETERMIKATION  OF  COSTS  3^1 

turing  for  the  idle  time  on  the  cost  book.  If  orders 
prove  to  have  been  charged  with  a  smaller  sum  for 
idle  time  than  the  cost  warrants  as  already  indi- 
cated, Idle  Time  will  have  a  debit  balance  and  show 
a  loss;  but  if  more,  as  will  be  the  case  if  idle  time 
is  being  eliminated  through  better  management  or 
through  improved  conditions,  it  will  show  a  credit 
balance,  and,  therefore,  a  gain.  The  only  purpose 
of  keeping  this  idle  time  in  an  account  by  itself  is 
to  learn  whether  the  amounts  charged  to  orders  are 
actually  more  or  less  than  the  final  cost  of  such  time. 
Minimum  Rates  is  next  to  be  credited  for  the  amount 
entered  on  the  cost  book  as  minimum  rates  and 
charged  to  manufacturing  orders;  for  the  things 
debited  to  this  account,  as  indicated  above,  have  pro- 
duced that  value  charged  to  orders.  The  correspond- 
ing debit  is  to  Manufacturing.  Power,  in  turn,  is 
debited  for  wages,  fuel,  depreciation,  taxes,  insur- 
ance, space  cost,  stores,  etc.,  and  is  credited  by  Addi- 
tional Rates.  Similarly,  Additional  Rates  is  charged 
with  superintendence,  machine  repairs,  oil,  power, 
etc.,  and  it  is  credited  by  a  transfer  to  Manufactur- 
ing. All  these  manufacturing  expenses  in  time  reach 
the  manufacturing  account,  and  the  final  debits  to 
Manufacturing,  for  pay  roll,  stores,  minimum  rates, 
additional  rates,  idle  time,  administration,  etc.,  show 
the  total  manufacturing  costs. 

It  is  notable  that  all  these  accounts  are  now 
balanced  except  Manufacturing,  which  contains  in 
itself  a  summary  of  all  the  others.  The  purpose  of 
keeping  these  others  is  simply  to  show  the  amount 
on  each  score  and  make  possible  a  comparison  with 
other  years. 


^72  ACCOUNTING  AND  AUDITING 

A  manufacturing  account  under  this  system, 
though  strictly  nominal,  for  it  represents  expenses, 
ought  practically  always  to  be  in  one  sense  real,  for 
it  should  represent  the  value  of  property  manu- 
factured. If  an  inventory  were  to  be  taken  of  un- 
finished goods  in  the  shop,  and  the  basis  of  valuation 
were  the  cost  so  far  incurred,  it  should  agree  with 
the  balance  of  the  manufacturing  account  as  shown. 
It  is  desirable  to  keep  up  the  adequacy  of  this  inven- 
tory wherever  possible.  Whenever  transfers  are 
made  from  the  shop  to  the  stock  room  (that  is,  the 
room  in  which  finished  goods  are  kept).  Stock  is 
debited  for  the  goods  at  the  exact  figure  of  cost,  as 
shown  by  the  cost  book,  and  Mamifacturing  is  cred- 
ited for  the  same  figure.  The  balance  of  Manufac- 
turing will  then  show  the  cost  or  value  of  goods  still 
in  the  shop.  If,  similarly,  when  goods  are  sold. 
Stock  is  credited  for  the  cost  price  of  the  goods  sold, 
and  Trading  account  is  debited  at  the  same  price, 
the  balance  of  Stock  represents  the  cost  of  finished 
goods  on  hand  in  the  stock  room.  If,  finally,  when 
goods  go  to  the  shipping  room.  Trading  is  credited 
at  the  selling  price,  the  balance  of  Trading  will  at  all 
times  show  the  profit  on  goods  sold.  Here,  then, 
is  a  complete  system  showing  at  all  times  the  inven- 
tories, the  costs,  the  relation  of  the  separate  items 
of  cost  to  the  various  groups  of  cost,  and  affording 
a  means  of  comparison  for  each  item  of  cost  with 
the  figures  for  other  years.  The  principles  here 
shown  are  applicable  in  practically  every  case;  the 
only  variations  will  be  those  required  by  the  peculiar 
circumstances  of  each  individual  shop. 

It  is  to  be  noted,  moreover,  that  this  principle  of 


DETERMINATION  OF  COSTS  373 

distribution  of  burden  is  applicable  in  many  other 
things  than  manufacturing.  In  most  lines  of  enter- 
prise, whether  of  a  commercial,  political,  or  chari- 
table nature,  it  is  desirable  to  know  what  is  got  for 
what  is  spent.  Only  when  an  attempt  is  made  to 
distribute  joint  costs  over  the  product  or  service 
rendered  can  a  manager  know  whether  he  is  getting 
his  money's  worth  or  whether  further  economies 
should  be  sought.  Nothing  could  be  further  from  the 
ordinary  commercial  enterprise,  at  least  in  purpose, 
than  the  conduct  of  a  charitable  hospital.  It  must 
be  realized,  however,  that  even  more  than  in  a  com- 
mercial enterprise  is  it  desirable  in  a  hospital  that 
the  most  shall  be  got  for  the  money;  for  the  donors 
have  given  money  in  trust  for  the  public  welfare,  and 
if  the  managers  cause  any  part  of  that  money  to 
produce  less  than  the  maximum  public  benefit,  they 
are  either  intentionally  or  by  neglect  cheating  the 
public  of  its  belongings.  Even  in  such  institutions, 
therefore,  cost  accounting  is  essential.  If  undue 
space  is  provided  for  administrative  officers,  doctors, 
and  nurses,  cost  is  unduly  increased.  If  the  patients 
in  private  wards  do  not  compensate  the  hospital 
sufficiently  for  their  accommodations  and  for  their 
food  and  treatment,  the  charity  public  is  cheated. 
Only  careful  cost  accounting  will  show  when  the 
costs  are  met. 


CHAPTER  XVI 

SETTLEMENTS  BASED  ON  ACCOUNTS 

An  accountant  is  likely  to  be  concerned  indirectly 
in  many  business  operations  which  are  out  of  the 
usual  course.  He  needs  to  know  something  of  law 
and  custom  in  relation  to  circimistances  that  may 
never  arise,  for  though  he  is  not  responsible  for 
carrying  out  any  operations,  he  is  responsible  to  see 
that  his  books  preserve  the  information  that  may  be 
required  by  those  in  authority.  An  accountant  is 
not  primarily  responsible  to  make  a  fair  distribution 
of  profits  between  partners,  for  instance;  but  his 
books  should  be  so  kept  that  the  person  making  the 
division  can  learn  the  desired  facts.  The  same  thing 
is  true  with  regard  to  trusteeships,  executorships, 
and  the  settlement  of  the  affairs  of  a  bankrupt.  Let 
us  take  these  in  order. 

In  partnerships,  the  books  must  show  the  facts 
with  regard  to  all  a  partner's  relations  with  the  busi- 
ness; for  partnership  agreements  may  provide  for 
so  many  elements  in  the  final  distribution  of  profits 
that  books  which  do  not  properly  distinguish  between 
these  various  elements  may  prove  at  any  time 
deficient.  If  a  partnership  agreement  does  not  specify 
how  profits  are  to  be  distributed,  the  presumption 
is,  unless  there  is  some  extraneous  evidence  to  the 
contrary,  that  the  partners  are  to  share  equally  in 

375 


376  ACCOUNT^ING  AND  AUDITING 

both  profits  and  losses.  Sometimes  a  partnership 
agreement  provides  that  profits  are  to  be  distributed 
in  the  ratio  of  partners'  investments — and,  of  course, 
it  is  assumed  that  the  lengtli  of  time  the  capital  is 
in  the  business  is  one  of  the  elements  of  the  invest- 
ment itself.  Sometimes  a  provision  is  made  that 
interest  on  capital  shall  be  allowed  partners  as  the 
first  element  of  profits,  and  that  after  this  provision 
is  made  the  profits  shall  be  distributed  on  some  other 
basis.  Sometimes  provision  is  made  for  definite 
salaries  to  be  allowed  to  partners.  This  is  common 
where  a  considerable  disproportion  exists  between 
the  amount  of 'investment  by  different  partners  and 
the  amount  of  personal  profit  which  they  are  ex- 
pected to  appropriate;  especially  is  this  common 
where  one  man  furnishes  the  capital  for  an  enter- 
prise which  he  little  understands  and  another  with 
little  or  no  capital  furnishes  the  knowledge  of  the 
business  and  the  managing  ability.  Sometimes 
provision  is  made  that  a  minimum  investment  shall 
be  maintained  by  each  partner  and  that  if  any  part- 
ner falls  behind  in  his  investment  he  shall  suffer  a 
penalty — usually  through  the  medium  of  an  interest 
charge.  Primarily,  an  accountant  is  not  expected 
to  pass  judgment  on  the  equity  of  a  partnership 
agreement;  but  since  it  is  his  task  to  see  how  the 
agreement  works  out  in  practice  as  applied  to  the 
figures  of  any  particular  business,  he  ought  to  be 
able  to  make  recommendations  to  his  superiors.  Let 
us  see  the  operation  of  the  various  provisions  for 
distribution  already  indicated. 

A  division  of  profits  without  regard  to  capital 
or  salaries  is,  of  course,  easy  to  administer  because 


SETTLEMENTS  BASED  ON  ACCOUNTS     377 

one  has  merely  to  determine  net  profits  and  divide 
it  equally  among  partners.  A  glance  at  the  books 
in  any  case  should  show  whether  that  is  likely  to  be 
approximately  fair.  If  the  capital  accounts  of  part- 
ners show  that  any  one  of  them  has  an  investment 
far  lower  than  that  of  the  others,  or  that  his  invest- 
ment is  for  a  shorter  period,  resulting  commonly 
from  a  withdrawal  of  funds  in  the  course  of  the  year, 
it  is  obvious  that  some  other  provision  should  be 
substituted  for  equal  division  among  partners, — 
unless,  indeed,  it  is  understood  that  the  partner  short 
in  capital  renders  special  service  in  other  respects. 
A  division  of  profits  on  the  basis  of  investment 
alone  is  almost  equally  simple;  for  if  one  partner 
has  an  investment  of  $15,000,  another  of  $10,000, 
and  another  of  $5,000,  it  is  obvious  that  the  division 
of  profits  should  give  one-half  to  the  first  (for  he  has 
invested  one-half  of  the  total  $30,000),  one-third  to 
the  second,  and  one-sixth  to  the  third.  It  is  equally 
obvious  that  if  the  personal  services  of  the  three 
partners  are  of  equal  importance,  the  r^tio  of  divi- 
sion is  unfair,  for  a  certain  sum  ought  to  be  pro- 
vided for  salaries  alone  and  then  the  remainder 
apportioned  on  the  basis  of  capital.  If  the  books 
show  that  the  amount  of  partners'  investments  has 
varied  from  month  to  month,  some  scheme  of  equali- 
zation is  necessary.  A  common  device  is  to  figure 
interest  on  those  investments  and  find  the  ratio  be- 
tween the  interest  on  the  investment  of  each  and  the 
total  interest  of  all  the  investments,  and  then  to 
apportion  profits  accordingly.  If  the  withdrawals 
are  usually  at  monthly  intervals,  however,  it  is  com- 
mon to  multiply  the  net  investment  each  month  by 


378  ACCOUNTING  AND  AUDITING  ^ 

the  number  of  months  it  remains  in  the  business  and 
get  as  a  result  a  sum  for  each  partner  equivalent  to 
an  investment  for  one  month.  A  comparison  of 
these  equivalent;  investments  will  show  how  profits 
are  to  be  distributed  between  partners.  If,  for 
example,  the  total  investment  of  the  first  partner 
multiplied  by  the  months  which  each  portion  was  in 
the  business  gives  $150,000,  of  the  second,  $75,000, 
and  of  the  third,  $50,000,  profits  should  be  divided 
on  the  basis  of  six-elevenths  (150/275),  three- 
elevenths,  and  two-elevenths, — instead  of  one-half, 
one-third,  and  one-sixth,  as  we  found  when  time  was 
neglected. 

When  provision  is  made,  as  is  common,  that  the 
first  charge  against  profits  shall  be  interest,  at  a 
fixed  percentage,  on  the  partners'  investments,  in- 
terest is  figured  on  each  partner's  investment  for  the 
time  it  is  in  the  business,  and  he  is  credited  on  his 
account  with  the  amount — which,  of  course,  is 
charged  to  Interest. 

Similarly,  when  provision  is  made  for  salaries,  or 
for  interest  and  salaries,  credits  are  made  to  the 
partners'  accounts  and  debits  to  Salaries,  or  Ex- 
pense, or  Profit  and  Loss,  as  the  case  may  be.  The 
remaining  profit  is  then,  as  before,  divided  between 
the  partners  equally  unless  there  is  provision  for 
some  other  basis. 

When  provision  is  made  for  penalties  to  be 
charged  to  partners  whose  capital  is  deficient,  a  com- 
plication arises  which,  without  advance  provision 
in  the  partnership  agreement,  may  cause  unfortunate 
differences.  If,  for  instance,  provision  is  made  that 
each  partner  shall  maintain  at  least  a  minimum 


SETTLEMENTS  BASED  ON  ACCOUNTS  379 

investment,  and  that  any  partner  whose  investment 
is  below  that  minimum  shall  be  charged  interest  on 
the  deficiency,  question  may  arise,  at  the  time  of 
making  the  charge  to  the  partner  for  this  interest, 
as  to  the  account  to  be  credited.  The  other  partners 
sometimes  demand  that  the  interest  charge  to  the 
delinquent  partner  shall  be  credited  directly  to  them 
in  proportion  to  their  shares  of  profits.  The  delin- 
quent partner,  on  the  other  hand,  claims  that  such 
credits  shall  be  made  directly  to  the  profit  and  loss 
account;  and  as  he,  because  he  is  a  partner  in  the 
business,  is  entitled  to  a  share  in  the  profits  of  the 
business,  he  is  entitled  to  his  share  of  the  profits 
resulting  to  the  business  from  charging  him  interest 
on  his  deficiency  of  capital.  Unless  there  is  specific 
provision  to  the  contrary,  it  is  obvious  that,  on  the 
basis  of  all  accounting  methods,  the  interest  charged 
the  delinquent  partner  is  an  earning  of  the  business, 
and  he  as  a  partner  is  entitled  to  share  in  it.  If  the 
partners  desire  that  penaltiqs  for  delinquencies  shall 
accrue  directly  to  other  partners,  provision  for  this 
should  be  made  in  the  partnership  agreement. 

Unless  provision  is  made  to  the  contrary  in  the 
partnership  agreement,  it  is  understood  that  losses 
shall  be  shared  on  the  same  basis  as  gains.  Under 
one  circumstance  the  books  are  likely  to  show  that 
this  works  great  hardship.  If  a  firm  has  not  good 
credit  because  of  poverty,  it  cannot  always  borrow 
all  the  money  it  needs  for  the  economical  conduct  of 
its  business,  and  for  any  partner  to  abstract  or  with- 
hold from  the  business  capital  which  he  ought  to 
maintain  is  to  hamper  the  business  and  possibly  not 
only  to  keep  from  it  profits  which  might  otherwise 


380  ACCOUNTING  AND  AUDITING 

accrue,  but  absolutely  to  cause  it  loss.  It  is  clearly 
unfair  that  under  these  circumstances  losses  should 
be  shared  on  the  basis  of  capital  investment;  for  then 
the  partner  straining  his  utmost  to  keep  up  th^ 
operating  capital  of  the  firm  suffers  most  in  the  divi- 
sion of  losses,  and  the  partner  who  has  withdrawn 
his  capital  suffers  least.  All  partnership  agree- 
ments should  provide,  therefore,  that  each  partner 
shall  maintain  a  minimum  capital,  and  that  on  defi- 
ciencies he  shall  be  charged  a  rate  of  interest  not  only 
as  much  as  the  market  rate  but  really  much  more; 
this  will  withdraw  from  him  the  temptation  to  sacri- 
fice a  business  in  which  he  has  only  a  share  and  devote 
his  capital  to  operations  from  which  he  will  derive 
the  sole  profit.  In  fixing  the  rate,  too,  one  should 
realize  that  if  this  charge  for  deficiency  in  capital 
is  to  be  carried  through  the  profit  and  loss  account, 
the  delinquent  partner  will  receive  a  share  of  the 
profit  from  his  own  penalty,  and  the  rate  should 
be  placed  at  a  point  that  will  make  it  effective. 

It  should  be  further  observed  that  often  partners 
loan  to  their  own  ^business  sums  of  money  which — 
as  is  distinctly  understood  not  only  by  them  but  by 
the  other  partners — are  not  invested;  such  loans, 
therefore,  are  not  entitled  to  profit  and  should  not 
share  in  losses — unless,  indeed,  the  partnership  goes 
into  insolvency,  in  which  case  the  loan  of  the  part- 
ner will  suffer  even  more  than  the  loans  of  out- 
siders (for  since  the  partner  is  himself  responsible 
to  the  full  extent  of  his  property  for  the  debts  of 
the  firm,  he  can  demand  nothing  by  way  of  payment 
until  all  outside  debts  have  been  met) . 

It  is  obvious  from  this  discussion  of  the  various 


SETTLEMENTS  BASED  OiST  ACCOUNTS  381 

methods  of  distributing  profits  that  the  bookkeeper 
must  be  careful  to  distinguish  between  the  various 
relations  of  each  partner  to  the  partnership.  It 
will  be  found  in  practical  experience  that  if  a  busi- 
ness has  suffered  loss,  and  especially  if  it  is  to  be 
dissolved  (so  that  final  settlements  must  be  made 
betw^een  partners),  distribution  of  assets  must  fol- 
low a  definite  order,  and  no  sum  must  be  given  to 
any  partner  on  account  of  one  of  his  relations  until 
all  sums  have  been  paid  to  other  partners  on  account 
of  prior  relations.  For  this  reason  there  must  be 
no  risk  of  confusion  on  books  between  a  partner's 
investment  account,  his  personal  (or  salary  and 
withdrawal)  account,  his  interest  account,  and  his 
loan  account.  It  is  impossible  in  a  book  of  this  sort 
to  discuss  the  various  difficult  complications  arising 
from  practical  problems,  and  we  must  content  our- 
selves here  with  the  observation  that  if  these  vari- 
ous relations  just  indicated  are  properly  distin- 
guished on  the  books,  a  person  familiar  with  the  law 
will  have  no  difficulty  in  making  final  settlements. 
We  saw  in  the  chapter  on  the  peculiarities  of 
corporation  accounting  that  provision  must  often 
be  made  for  good  will.  It  is  not  usually  desirable  in 
a  partnership  that  partners  shall  be  given  credit  for 
the  amount  of  good  will  belonging  to  the  business, 
even  though  it  be  known  that  this  is  a  large  item; 
for  any  sum  shown  by  the  books  as  credited  to  a  part- 
ner in  excess  of  the  minimum  required  by  the  part- 
ners' agreement  may  be  by  him  withdrawn.  It  is 
obvious,  however,  that  good  will  is  not  subject  to 
withdrawal;  for  it  exists  only  in  connection  with  the 
running  of  the  business,  and  the  moment  it  is  with- 


m  ACCOUNTING  AND  AUDITING 

drawn  from  actual  connection  with  the  business  it 
disappears.  Partnership  agreements  sometimes  pro- 
vide, however,  that  in  case  of  the  decease  of  a  part- 
ner his  heirs  shall  be  entitled  to  recover  from  the 
firm  the  deceased  partner's  share  of  the  good  will. 
Here,  however,  it  is  to  be  noted  that  the  good  will 
is  not  withdrawn  from  the  business,  for  the  remain- 
ing partners  purchase  that  good  will  from  the  heirs 
of  the  partner  deceased  and  they  maintain  it  in  the 
business.  In  such  a  case,  of  course,  the  proper  thing 
is  to  figure  the  good  will  on  the  basis  provided  by 
the  partnership  agreement  and  credit  the  amount 
to  the  deceased  partner.  When  payment  is  made, 
his  account  is  balanced,  and  the  good  will  appears 
on  the  books  as  an  asset;  for  the  original  entry  must 
have  been  a  debit  to  Good  Will  and  a  credit  to  the 
account  of  the  deceased  partner.  This  gdT)d  will  may 
properly  stand  as  an  asset  on  the  books;  for  unless 
overstated  it  represents  a  value  which,  though  in- 
tangible, is  quite  as  real  as  that  of  tangible  things, 
and,  since  it  has  cost  the  present  partners  some  value, 
on  the  theory  that  the  only  proper  basis  for  capital 
charges  is  cost  or  sacrifice  it  may  stand  on  the  books 
as  an  asset.  It  is  true,  of  course,  that  the  good  will 
which  properly  belongs  to  the  remaining  partners 
is  a  true  asset,  but  since  it  may  not  be  withdrawn 
by  them,  though  it  may  be  transferred,  it  should 
not  appear  as  credited  to  their  accounts — and,  there- 
fore, cannot  appear  at  all. 

In  an  early  chapter  attention  was  called  to  the 
fact  that  single  entry  is  not  scientific  bookkeeping, 
for  it  does  not  show  sources  of  profit  nor  causes  of 
loss.    An  accountant  is  often  asked  to  provide  inf or- 


SETTLEMENTS  BASED  ON  ACCOUNTS  383 

mation  necessary  for  a  partnership  settlement  from 
books  kept  only  by  single  entry.  It  is  desirable 
here,  therefore,  to  make  a  sliglit  examination  of  sin- 
gle entry.  Under  the  strict  single-entry  method  no 
accounts  are  kept  except  for  property  and  claims. 
When  merchandise  is  sold,  the  only  record  made  is 
a  debit  to  the  customer;  when  a  note  is  received 
from  a  customer,  the  only  entry  is  a  credit  to  the 
customer;  when  cash  is  paid  for  wages,  no  entry 
is  made  on  any  book  which  will  lead  to  the  ledger, 
but  the  item  is  w^ritten  on  the  cash  book  in  order 
to  enable  the  bookkeeper  to  see  how  much  cash  he 
ought  to  have  on  hand.  Usually,  in  practice,  a  little 
of  the  double-entry  method  is  incorporated  in  single- 
entry  books,  and  credits  are  made  to  Bills  Payable, 
for  instance,  when  notes  are  issued,  and  debits  to 
Bills  Receivable  for  notes  received.  Even  then, 
however,  the  books  are  not  double-entry  books,  for 
no  attempt  is  made  to  produce  equality  between  the 
two  sides  of  the  ledger.  Under  the  single-entry 
theory,  since  assets  can  always  be  counted,  no  need 
exists  for  entry  on  the  books.  The  method  of  learn- 
ing profit  or  loss  under  single-entry  is  the  method 
pursued  in  proving  the  six-column  statement  by 
double-entry;  that  is,  a  comparison  of  the  balance  of 
resources  and  liabilities  at  the  end  of  the  year  with 
that  at  the  beginning  of  the  year  shows  (except 
for  withdrawals  and  new  investment  of  capital  by 
partners)  the  profit  or  loss  of  the  year's  operations. 
Under  double  entry,  it  will  be  remembered,  the  books 
give  two  methods  of  learning  profit, — one  by  a  com- 
parison of  assets  and  liabilities,  the  other  by  a  com- 
parison of  losses  and  gains.  The  single-entry  method 


384  ACCOUNTING  AND  AUDITING 

of  determining  total  profit  or  loss  is  quite  as  good  as 
the  other,  if  it  can  be  assumed  that  no  errors  have 
been  made  on  the  books ;  but  since  it  shows  no  details 
and  gives  no  indication  of  the  sources  of  profit 
or  causes  of  loss,  it  is  entirely  inadequate,  and 
furnishes  no  basis  at  all  for  any  accounting  properly 
so  called.  When,  therefore,  one  has  to  learn  from 
single-entry  books  what  profit  has  been  made  by  a 
partnei^hip,  one  has  only  to  draw  up  a  statement 
of  assets  and  liabilities  for  the  year  in  question  and 
compare  it  with  a  similar  statement  for  the  year 
before — making  allowance,  of  course,  for  with- 
drawals .-and  investments  by  partners.  If  a  state- 
ment for  the  present  time  compared  with  that  of  the 
earlier  time  shows  no  change,  it  is  obvious  that  the 
profit  equals  the  withdrawals  of  partners — that  is 
to  say,  the  partners  have  withdrawn  during  the  year 
just  the  profits  made.  If,  on  the  other  hand,  there  is 
no  increase  of  assets  and  the  partners  have  added  to 
their  investment  during  the  year,  as  shown  by  their 
capital  acounts  (which,  of  course,  must  be  main- 
tained even  in  single  entry,  to  show  how  much  of  the 
capital  belongs  to  each  partner),  the  business  has 
lost  the  siun  of  such  additional  investments.  If 
the  difference  between  the  statements  of  resources 
and  liabilities  shows  increased  assets,  the  actual 
profit  is  that  increase  plus  all  withdrawals  by  part- 
ners— for  in  spite  of  the  sums  withdrawn  profits  still 
exist  in  the  business,  and  so  the  total  profits  have 
been  present  profits  plus  withdrawals. 

Let  us  turn  next  to  trusteeships.  Their  peculi- 
arity is  that  the  distinction  between  capital  and 
revenue  is  under  them  likely  to  be  much  more  im- 


SETTLEMENTS  BASED  ON  ACCOUNTS  385 

portant  than  in  ordinary  business  transactions.  If, 
for  instance,  the  trustee  is  executor  or  administrator 
under  a  will,  and  the  will  provides  that  the  ^^ corpus" 
of  the  estate — that  is,  the  body  of  the  estate  as  dis- 
tinguished from  income — shall  be  paid  ultimately  to 
one  person,  but  the  income  of  property  shall  be  paid 
to  one  or  more  others,  the  trustee  must  realize  that 
the  corpus  of  the  estate  is  the  value  of  the  estate  at 
the  moment  of  death.  Very  few  business  relations, 
however,  reach  culmination  day  by  day.  If,  for 
example,  the  testator  held  bonds  on  which  interest 
is  regularly  collected  or  real  estate  on  which  rent  is 
regularly  collected,  the  interest  and  the  rent  accrued 
on  the  day  of  death  (though  not  yet  due)  belong  to 
the  inheritor  of  the  corpus  of  the  estate,  but  all  in- 
come from  these  sources  accruing  later  and  begin- 
ning to  accrue  on  the  day  of  death  belongs  to  those 
who  hold  the  life-interest,  or  income.  It  is  necessary 
for  the  trustee  in  keeping  his  books  of  account,  there- 
fore, to  see  that  all  the  elements  of  the  estate  are 
valued  as  of  the  day  of  death,  even  though  collected 
later,  'and  that  all  sums  earned  later  are  shown  on 
his  books  as  income. 

Under  the  law  of  most  states  the  title  of  all 
personal  estate  vests  immediately  on  death  in  the 
executor  or  administrator,  and  therefore  he  should 
keep  books  of  account  showing  his  responsibility  to 
the  estate.  Real  estate,  however,  under  the  law  of 
most  states,  does  not  vest  in  a  trustee,  but  passes 
at  once  to  the  beneficiaries  under  the  will  or  under 
the  general  law,  and,  therefore,  the  trustee  does  nov 
ordinarily  need  to  record  real  estate  on  his  books. 
His  first  entry,  after  making  an  appraisal  of  tht 

A  &  A-25 


^g6  ACCOtJNTlKG  AJ^D  AUDITING 

estate,  then,  is  a  debit  to  the  accounts  representing 
specific  kinds  of  property,  and  a  credit  to  the  per- 
sonal estate  of  the  deceased.  When  any  changes 
occur,  such,  for  instance,  as  collections  of  rents  and 
interest,  he  debits  Cash,  as  in  ordinary  cases,  and 
credits  the  personal  estate  for  that  sum  which  had 
accrued  at  the  time  of  death,  and  credits  Income  for 
•its  due  share.  When  any  payments  are  made  to  bene- 
ficiaries entitled  to  the  income  of  the  estate.  Income 
is,  of  course,  debited  for  those  payments,  and  Cash, 
or  the  other  necessary  property  account,  is  credited. 
If  at  the  time  of  death  rentals  have  accrued  on  real 
estate  which  is  under  the  will  or  under  the  general  law 
transferred  directly  to  beneficiaries,  the  trustee  will 
collect  the  rental  on  the  next  date  of  payment  and 
will  credit  to  Income  the  sum  accrued  since  death. 
The  sum  accrued  at  the  time  of  death  will  have  been 
already  debited  to  Eentals  Accrued  at  the  time  the 
books  were  opened,  and  credited  to  personal  estate. 
Many  problems  of  executorship  involve  careful  and 
complicated  computations  of  the  exact  division  be- 
tween income  and  principal.  Their  solution  should 
be  undertaken  only  by  persons  familiar  with  the 
mathematics  of  investment. 

We  may  turn  next  to  insolvency.  In  case  a 
trustee  is  required  to  settle  the  affairs  of  an  estate, 
individual,  partnership,  or  corporation,  in  insolvency, 
he  must  see  that  he  has  acquitted  himself  not  only  in 
reality  but  on  his  books  for  all  responsibility  as- 
sumed. The  first  step  is  usually  to  make  an  esti- 
mate, for  general  guidance,  as  to  the  probable  yield 
of  assets.  This  is  usually  made  in  the  form  of  what 
is  called  a  *' statement  of  affairs."    Such  a  state- 


SETTLEMENTS  BASED  ON  ACCOUNTS  387 

ment  usually  has  the  liabilities  on  the  left  side  of  the 
sheet,  because,  since  its  purpose  is  to  show  how  far 
the  property  is  likely  to  liquidate  liabilities,  the 
first  concern  is  to  show  what  is  the  amount  of  such 
liabilities.  Usually  several  classes  of  liabilities,  with 
different  degrees  of  security,  are  to  be  met.  The 
order  in  which  items  shall  appear  is  not,  of  course, 
of  great  moment,  and  the  desirable  thing  is  not  so 
much  to  show  totals  as  to  show  for  each  class  of 
liabilities  how  it  will  probably  fare  in  final  settle-' 
ment.  Any  assets  that  must  of  necessity  apply  to 
specific  liabilities,  such  as  securities  pledged  as 
collateral,  should  be  connected  with  those  liabilities. 
So  far  as  any  liabilities  are  wholly  secured,  they  do 
not  affect  the  solvency  of  the  business,  and  need  to 
appear  on  the  statement  only  to  show  that  they  have 
not  been  forgotten  or  that  they  absorb  certain  assets 
which  otherwise  would  be  useful  in  liquidating  other 
liabilities.  The  primary  purpose  of  a  statement  of 
affairs,  therefore,  is  to  show  the  unpledged  assets  in 
their  relation  to  the  unsecured  debts.  Naturally 
the  first  item  is  commonly  the  amount  due  to  unse- 
cured creditors.  Next  is  usually  stated  the  amount 
of  secured  liabilities,  with  the  estimated  value  of 
the  security  pledged;  any  excess  value  of  the  security 
is  therefore  free  and  available  to  set  among  the 
resources  on  the  other  side  of  the  sheet, — unless, 
indeed,  some  of  this  surplus  may  be  specially  claimed 
by  creditors  partially  secured.  (See  page  389.) 
Next  among  the  liabilities  come  simis  due  to  credit- 
ors partly  secured,  and  from  this  is  subtracted  the 
estimated  value  of  the  security  pledged  for  those  lia- 
bilities; the  balance,  or  excess  liability,  is  added  to 


388  ACCOUNTING  AND  AUDITING 

the  sums  due  to  unsecured  creditors.  Next  are 
added  the  liabilities  on  notes,  the  contingent  liabil- 
ities, and  finally  the  liabilities  to  preferred  creditors, 
such  as  those  for  taxes,  for  fees  in  insolvency,  for 
wages,  etc.  From  this  last  class  are  deducted  funds 
found  on  the  other  side  to  be  available  for  the  pay- 
ment of  such  preferred  claims;  for  since  these  claims 
are  legal  preferential  claims,  they  absorb  the  first 
free  assets,  and  if  sufficient  free  assets  are  available 
to  provide  for  them,  they  disappear  as  unsecured 
liabilities.  On  the  assets  side  of  the  sheet  the  gen- 
eral list  of  property  is  given  first.  Next  follow  the 
accounts  receivable,  which  are  classified  as  good — 
of  which  the  amount  is  extended  into  the  total 
column, — the  doubtful — for  which  an  estimate  is 
made  as  to  the  probable  yield  and  the  amount  ex- 
tended into  the  total  column, — and  the  bad — which, 
of  course,  will  yield  nothing  for  the  total  column. 
Next  follow  the  bills  receivable  with  their  estimated 
value;  then  the  surplus  from  any  values  pledged  to 
the  secured  creditors,  as  shown  by  the  subtraction 
from  the  second  item  of  liabilities.  From  the  total 
of  these  may  be  seen  readily  whether  any  sums  are 
immediately  available  to  be  laid  aside  for  the  pref- 
erential claims — as  previously  indicated;  and  if  so 
they  are  at  once  deducted  and  applied  to  such  claims 
on  the  other  side.  The  total  free  assets  now  compared 
with  the  total  unsecured  liabilities  will  show  probable 
deficiency.  This,  of  course,  is  added  as  the  last  item 
on  the  resource  side  to  balance  the  statement.  A 
form  is  given  below. 


SETTLEMENTS  BASED  ON  ACCOUNTS 


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390  ACCOUNTING  AND  AUDITING 

The  next  task  of  the  trustee  is  to  realize  on  the 
property.  A  common  form  of  recording  this  on  books 
of  account  is  what  is  called  a  '^realization  and  liqui- 
dation account.''  If  it  is  undesirable  to  close  at  once 
on  the  books  all  asset  and  liability  accounts  into  the 
realization  and  liquidation  account,  an  artificial  ad- 
justment account  may  be  credited  for  the  necessary 
debits  to  Realization  and  Liquidation,  and  debited  for 
its  credits.  The  first  entry  under  this  plan  will 
debit  Realization  and  Liquidation  for  all  assets  at 
their  book  value — ^f or  the  book  value  naturally  repre- 
sents the  theoretical  basis  on  which  the  realization 
will  proceed.  The  adjustment  account  will  be  credited 
for  the  same  sum.  Next,  Realization  and  Liquida- 
tion will  be  credited  for  all  liabilities  to  be  liqui- 
dated, and  the  adjustment  account  will  be  debited 
for  the  same  sum.  The  result  of  these  two  entries 
is  that  Realization  and  Liquidation  shows  the  book 
value  of  assets  with  which  liabilities  must  be  liqui-* 
dated,  and  the  amount  of  such  liabilities  to  be  liqui- 
dated. (See  page  392.)  Among  the  liabilities, 
however,  would  not,  of  course,  be  included  the  pro- 
prietor's capital,  for  since  this  is  an  inside  relation 
it  does  not  need  liquidation  in  the  ordinary  sense. 
As  soon  as  any  sum  has  been  realized — ^by  the  col- 
lection of  accounts  receivable  and  bills  receivable  or 
the  sale  of  merchandise,  for  instance, — Realization 
and  Liquidation  should  be  credited,  for  that  sum 
has  gone  to  reduce  the  amount  which  the  trustee  is 
responsible  to  realize  on.  As  soon,  on  the  other  hand, 
as  any  of  the  sums  so  realized  have  been  applied  to 
the  liquidation  of  liabilities.  Realization  and  Liqui- 


SETTLEMENTS  BASED  ON  ACCOUNTS  391 

dation  is  debited  for  those  sums,  for  the  trustee  has 
performed  to  that  extent  his  task  of  liquidation. 
Since,  moreover,  whenever  realization  or  liquidation 
has  been  carried  out,  the  original  property  and  lia- 
bilities on  the  books  are  now  disposed  of,  entries 
should  be  made  to  the  adjustment  account  and  to 
the  asset  and  liability  accounts  on  the  books  so  as  to 
bring  the  books  into  accord  with  the  latest  situation. 
If,  for  instance,  $5,000  is  collected  by  the  trustee  on 
bills  receivable,  and  with  it  $5,000  of  bills  pay- 
able is  liquidated,  the  first  entry  is  to  debit  Cash  and 
credit  Realization  and  Liquidation,  for  the  realiza- 
tion, the  second,  to  debit  Realization  and  Liquidation 
and  credit  Cash,  for  the  liquidation,  the  third,  to  debit 
Adjustment  and  credit  Bills  Receivable,  to  close  Bills 
Receivable  on  the  books,  the  fourth,  to  debit  Bills 
Payable  and  credit  Adjustment,  to  close  Bills  Pay- 
able. If,  in  the  process  of  realization  and  liquida- 
tion, expenses  are  incurred,  as  is  practically  inevi- 
table. Realization  and  Liquidation  is  debited  and 
Cash  is  credited;  for  these  expenses  paid  are,  from 
the  point  of  view  of  the  trustee,  equivalent  to  liabili- 
ties liquidated.  This  charge  does  not  need  to  appear 
on  the  old  books  in  connection  with  any  old  account  or 
on  the  adjustment  account,  for  it  has  no  relation  to 
the  old  business  except  as  Realization  and  Liquida- 
tion registers  the  settlement  of  old  affairs.  Realiza- 
tion and  Liquidation  is  shown  below  for  the  condi- 
tions of  the  statement  of  affairs  shown  on  page  389. 
It  is  assimaed  that  the  estimates  made  there  prove 
accurate ;  otherwise  the  loss  and  deficiency  would  be 
affected. 


392  ACCOUNTING  AND  AUDITING 

BEALIZATION   AND   LIQUIDATION 

(Assets  at  book  value)         $  91,000      (Liabilities  on  the  books)     $  57,000 
(Liquidation  of  liabilities,  (Contingent    and    accrued 

first  claims)  19,800  liabilities)  16,950 

(Percentage  paid  to  unse-  (Realized  from  assets)  46,000 

cured  creditors)  26,050       (Loss  on  realization)  45,000 

(Legal  claims)  150 

Deficiency   (unliquidated 

liabilities)  27,950 


$164,950  $164,950 


This  Realization  and  Liquidation,  as  usually  pre- 
sented, is  far  from  clear;  for  it  is  a  mixture  of  unlike 
things.  Debits  to  it  may  be  assets  to  be  realized  on, 
or  liabilities  liquidated,  o:^  expenses  of  liquidation; 
and  credits  may  be  either  assets  realized  or  liabilities 
to  be  liquidated.  The  result  is  that  no  one  can  tell 
whether  all  liabilities  have  been  liquidated  unless 
he  examines  the  detailed  records.  The  purpose  is 
served  more  clearly  by  opening  separate  accounts 
for  each  of  the  three  elements  of  the  combined  ac- 
count, and  calling  them  ^^Realization,"  ^^Liquida- 
tion," and  ^^ Expense  of  Liquidation."  The  balance 
of  Liquidation  shows  how  many  liabilities  at  any 
time  remain  unliquidated.  The  balance  of  Reali- 
zation shows  at  any  time  how  far  the  realizations 
have  approached  the  book  value  of  assets.  Expense 
of  Liquidation  shows  the  costs.  If,  when  all  assets 
have  been  realized  and  utilized  as  far  as  they  will 
go  in  paying  debt,  Liquidation  still  has  a  credit  bal- 
ance (showing  debts  outstanding),  the  capital  of  the 
business  has  been  exhausted  and  some  creditors  are 
still  unpaid.    These  three  accounts  are  shown  below. 


SETTLEMENTS  BASED  ON  ACCOUNTS  393 

REALIZATION 

(Assets  at  book  value)            $91,000      (Realized  from  assets)  $46,000 

(Loss  on  realization)  45,000 

$91,000  $91,000 


LIQUIDATION 

(Liquidation,  first  claims)     $19,800      (Liabilities  on  the  books)       $57,000 
(Liquidation,  percentage  to  (Contingent  and  accrued)         16,800 

unsecured  creditors)  26,050 

Deficiency  27,950 

$73,800  $73,800 


EXPENSE  OF  LIQUIDATION 
(Payment)  $150      (Legal  fees)  $150 

When  affairs  have  been  settled,  it  is  convenient 
to  have  in  one  table  or  one  account  a  complete  state- 
ment of  deficiency,  if  any  has  resulted.  What  is 
ultimately  affected  by  the  deficiency  will  depend  in 
part  upon  the  amount  of  that  deficiency.  If  the 
business  has  accumulated  a  surplus  of  $20,000,  and 
the  deficiency  proves  to  be  but  $10,000,  clearly  only 
the  surplus  account  is  affected;  if,  on  the  other  hand, 
the  deficiency  is  $50,000,  surplus  is  $20,000,  and  part- 
ners'  capital,  $70,000,  the  deficiency  has  wiped  out 
the  surplus  and  made  a  severe  inroad  into  capital, 
so  that  the  net  result  is  a  remaining  partners'  capi- 
tal of  $40,000.  If,  finally,  the  deficiency  is  for  $100,- 
000,  and  the  other  accounts  are  as  just  indicated,  the 
deficiency  has  wiped  out  the  surplus,  the  capital, 
and,  if  the  partners  are  now  insolvent,  a  part  of  the 
debts  due  to  outsiders. 

One  interested  in  the  business,  moreover,  desires 
to  know  not  only  what  has  been  the  ultimate  result 


394  ACCOUNTING  AND  AUDITING 

of  the  deficiency,  but  also  from  what  it  has  origi- 
nated. A  deficiency  account  may  indicate  whether 
the  loss  has  arisen  from  a  shrinkage  of  assets,  from 
a  destruction  of  assets,  from  outside  claims  made 
against  the  business  because  of  its  usual  operations 
— such  as  bankruptcy  of  business  houses  whose  notes 
the  firm  has  accepted  and  has  discounted  or  other- 
wise transferred  to  others  on  endorsement, — or  from 
accommodation  endorsements  for  outsiders  by  way 
of  friendship — which,  of  course,  are  not  normal  or 
(in  a  sense)  legitimate  business  operations.  This 
can  be  easily  shown  by  a  deficiency  account  giving 
on  one  side  capital  items,  or  items  connected  with 
capital,  and  on  the  other  side  the  changes  in  assets 
affected  by  realization  and  either  shrunk  or  des- 
troyed, with  the  liabilities  thrust  upon  the  business 
from  outside — that  is,  claims  not  arising  from  its 
operation,  but  demanding  the  surrender  of  assets 
for  which  the  business  has  received  no  adequate 
return.  Assuming  the  capital  to  be  shown  on  the 
books  as  $34,000,  this  form  of  deficiency  account 
would  be  as  follows : 

(Compare  with  pages  389  and  393.) 

DEFICIENCY 

Eealization  (loss)  $45,000      Capital  $34,000 

Liquidation  (new  liabilities)    16,800      Balance   (net  insolvency)         27,950 
Expense  of  Liquidation  150 

'  $61,950  $61,950 


As  has  been  suggested  in  other  connections, 
though  a  ledger  form  for  such  a  statement  is  con- 
venient for  the  accountant,  it  is  not  always  clear  to 
persons  not  familiar  with  books  of  account.     This 


SETTLEMENTS  BASED  ON  ACCOUNTS  395 

deficiency  account  may  be  very  easily  presented  in 
ledger  form,  but  is  likely  to  be  more  intelligible  if 
in  the  form  of  a  statement  with  subtractions  where- 
ever  they  naturally  belong.  It  is  always  possible 
to  draw  such  a  statement  so  that  its  relation  to  other 
statements  with  which  it  is  connected  shall  be  ob- 
vious. In  this  case,  therefore,  the  amount  of  defi- 
ciency, as  sho\^ai  by  the  deficiency  account,  should 
agree  in  amount  and  in  detail  with  the  statement  of 
affairs  and  the  realization  and  liquidation  account. 
Commonly,  accountants  make  reports  which,  though 
intelligible  to  persons  familiar  with  bookkeeping, 
mean  practically  nothing  to  anyone  else,  for  not  only 
are  the  contra  items  meaningless,  but  the  items  which 
are  common  to  various  sheets  are  given  titles  which 
hide  common  relations,  and  the  novice  is  unable  to 
see  the  information  that  he  wants  either  in  any  one 
of  these  accounts  or  in  the  relations  between  them. 
Below  will  be  found  a  form,  for  the  situation  de- 
scribed above,  which  is  clear  and  intelligible  for  all 
readers  familiar  with  commercial  terms  and  with 
simple  figures.  ^ 


Depreciation  on  assets,  as  shown  by  Kealization: 
Book  value 
Eealization 

$91,000 
46,000 

$45,000 

Liability  for  commercial  endorsements 
Liability  for  accommodation 

1 

14,000 
2,000 

Total  losses 

$61,000 

Capital  invested 

Profits  accumulated                             , 

30,000 
7,000 

Withdrawals  of  capital 

$37,000 
3,000 

Capital  as  per  books 
Accrued  expenses 

$34,000 
950 

Net  nominal  capital 

33,050 

Deficiency,  or  net  insolvency 

$27,950 

CHAPTER  XVn 


AUDITING 


Under  the  general  title  of  ^^ auditing"  are  usually 
included  several  kinds  of  work  that  ought  to  bear 
another  name.  Auditing  strictly  so-called  shoiild 
include  only  thorough  examinations  of  books  to  make 
sure  that  the  final  conclusions  presented  in  the  in- 
come sheet  and  the  balance  sheet  are  warranted  by 
the  original  documents.  Among  special  examina- 
tions which  ought  properly  to  be  given  some  other 
name  are  examinations  by  professional  auditors  to 
gather  for  outsiders  certain  specific  information 
about  businesses  in  which  they  are  interested.  If  a 
man  is  contemplating  an  investment  in  a  business  as 
a  partner  or  a  stockholder,  for  instance,  he  may  em- 
ploy an  auditor  to  learn  whether  the  sales  are  as  large 
as  stated,  whether  the  property  is  as  valuable  as 
stated,  and  whether  the*  business  of  the  past  warrants 
certain  conclusions  with  regard  to  the  future.  Such 
a  study  of  the  books  requires  work  similar,  as  far  as 
it  goes,  to  that  of  an  ordinary  audit,  but  it  is  com- 
monly called  simply  an  ' '  examination. "  Of  a  similar 
nature  may  be  an  examination  for  a  person  invited  to 
lend  money  to  a  business,  for  he  desires  to  know  the 
probability  not  only  of  solvency,  but  also  of  earnings; 
he  wishes  assurance  of  the  payment  of  his  debt  with- 
out legal  procedure  in  bankruptcy. 

397 


398  ACCOUNTING  AND  AUDITING 

The  two  main  purposes  of  an  audit  are  to  detect 
fraud  and  to  detect  errors.  It  has  happened  often 
that  books  have  been  seriously  misleading  not  be- 
cause anybody  intended  to  mislead,  but  merely  be- 
cause ignorance  led  to  erroneous  accounting  or  book- 
keeping. If  it  is  suspected  that  anyone  concerned 
with  the  books  has  fraudulent  intention,  the  exami- 
nation will  proceed  on  somewhat  different  lines  from 
that  when  only  innocent  error  is  feared;  but  the 
difference  of  method  cannot  be  very  extensive,  for 
fraud  has  often  been  detected  where  there  was  no 
slightest  suspicion  before  the  audit.  The  method  of 
an  audit,  then,  should  be  based  on  the  realization 
that  many  men  perfectly  honest  are  likely  to  make 
errors,  and  that  many  men  apparently  honest  are 
likely  to  commit  fraud.  The  examination  should  be 
so  conducted  that  neither  error  nor  fraud  can  escape 
detection,  and  in  such  fashion  that  one  bent  on  com- 
mitting fraud  cannot  in  the  progress  of  the  audit 
cover  up  his  tracks  so  that  by  false  entries  on  the 
books  he  transfers  his  error  from  work  which  the 
auditor  has  not  yet  examined  to  that  which  he  has 
passed.  As  a  matter  of  fact,  there  are  very  few 
errors  committed  with  fraudulent  intention  which 
might  not  also  chance  to  creep  in  by  carelessness  or 
ignorance.  Many  men  are  so  loath  to  stand  com- 
mitted of  innocent  error  that  they  are  likely  by  what 
they  consider  a  perfectly  innocent  method  to  attempt 
to  cover  up  their  mistakes  while  an  auditor  is  en- 
gaged in  examining  the  books;  and  by  making  entries 
surreptitiously  in  work  which  the  auditor  has  already 
passed  they  may  upset  a  large  part  of  the  value  of 
the  work  which  he  has  already  done.    For  an  auditor 


AIJDITi:^G  399 

to  refuse  to  trust  anyone,  to  insist  on  seeing  every- 
thing absolutely  correct,  and  to  refuse  to  allow 
changes  in  work  which  he  has  passed,  is  only  to  pro- 
tect himself  against  waste  of  labor  and  is  not  to  cast 
doubt  or  suspicion  on  the  work  of  those  regularly 
engaged  on  the  books. 

The  errors  which  auditing  is  to  discover  are  of 
two  sorts.  The  first  are  mere  errors  of  bookkeeping 
which  result  in  wrong  figures.  These  are  purely 
technical,  of  course,  and  their  discovery  and  correc- 
tion are  easy,  for  they  do  not  involve  judgment.  The 
second  class  of  errors,  those  which  arise  from  neglect 
of  some  accounting  principle,  either  through  forget- 
fulness  of  some  element  in  a  problem  or  through  bad 
judgment  in  the  use  of  that  element,  are  more  or  less 
difficult  of  detection;  for  the  auditor  very  commonly 
is  not  thoroughly  informed  about  the  details  of  the 
business  and  cannot  always  see  in  his  mind's  eye  all 
the  elements  of  the  problem  before  him.  It  is  the 
auditor's  function,  however,  to  watch  carefully  to 
see  that  proper  accounting  principles  are  applied  in 
all  cases  which  come  to  his  attention. 

The  detection  of  fraud  is  much  more  difficult,  for 
a  person  imdertaking  to  commit  fraud  is  usually  in  a 
position — and,  of  course,  has  the  intention — to  cover 
up  his  tracks.  Of  frauds,  again,  two  classes  are  to 
be  observed.  The  first  are  the  fraudulent  entries 
made  by  subordinate  employees  in  violation  of  orders 
given  to  them  by  their  superiors.  The  commonest 
form  of  this  kind  of  fraud,  of  course,  is  that  which 
leads  to  the  possibility  of  extracting  cash.  Actual 
theft  of  property  other  than  cash  is  less  common, 
and  much  harder  to  detect;  but  since  it  always  re- 


400  ACCOUNTING  AND  AUDITING 

quires,  if  carried  on  largely,  assistance  in  disposing 
of  the  property,  collusion  is  likely  sooner  or  later  to 
be  detected.  Fraud  committed  by  members  of  a 
partnership  against  their  colleagues  or  by  officers  of 
a  corporation  against  the  stockholders  is  often  diffi- 
cult for  an  auditor  to  detect,  for  the  person  commit- 
ting the  fraud  is  trusted  by  others,  and  he  has  infor- 
mation about  the  conduct  of  the  business  which  is 
beyond  the  auditor's  power  to  secure.  In  such  cases 
an  auditor's  ability  to  discover  fraud  lies  chiefly  in 
his  general  knowledge  of  business  conditions;  for  he 
can  make  comparisons  between  figures  which  he  can 
get  for  this  particular  business  and  figures  warranted 
by  his  general  experience.  When  he  finds  any  con- 
siderable discrepancy  between  general  figures  and 
the  figures  disclosed  for  this  business,  it  is  his  duty 
to  investigate. 

The  extent  of  the  work  an  auditor  shall  do  must 
be  determined  for  him  in  every  case  by  the  form  of 
contract  which  engages  him.  In  the  ordinary  course 
of  his  work  he  is  likely  to  come  across  many  transac- 
tions which  it  is  impossible  for  him  to  pass  judg- 
ment upon.  In  such  a  case  he  may  well  request  a 
partner  or  an  officer  to  sign  a  statement  assuming  re- 
sponsibility for  that  entry.  In  the  auditor's  final 
report  he  may  well  call  attention  to  the  fact  that  this 
item  is  one  upon  which  it  was  impossible  for  him  to 
pass  judgment,  and  that  it  is  vouched  by  a  person  in 
authority.  The  auditor  is  not  performing  his  duty, 
however,  if  he  falls  back  on  such  a  statement  signed 
by  a  partner  or  officer  in  any  case  which  he  is  able 
to  investigate  for  himself;  for  since  the  purpose  of 
the  audit  is  to  certify  the  correctness  of  the  books 


AUDITING  401 

from  an  outside  examination,  in  every  case  in  which 
he  accepts  the  statement  of  an  officer  as  to  correct- 
ness, he  is  by  so  much  failing  to  perform  the  work 
which  he  was  hired  to  perform;  and,  therefore,  such 
statements  should  be  used  only  in  cases  where  it 
would  naturally  be  the  auditor's  task  to  verify  the 
item  but  from  peculiar  circumstances  he  is  unable 
to  do  so. 

The  first  task  in  auditing  is  to  learn  what  is  re- 
quired by  the  documents  to  be  on  hand  at  the  date  of 
audit.  If  the  books  were  known  to  be  correct  at 
the  beginning  of  the  period  (because  a  previous  audit 
has  proved  their  correctness,  or  because  the  business 
was  started  at  that  time,  or  because  those  engaging 
the  audit  are  willing  to  accept  the  books  as  correct 
at  the  beginning  of  the  period),  and  the  property 
now  on  hand  is  found  by  the  auditor  to  agree  with 
the  property  required  by  the  records  to  be  on  hand, 
the  audit  is  complete  so  far  as  its  primary  purpose — 
the  discharge  of  responsibility — ^is  concerned.  It  is 
obvious,  however,  that  since  the  purpose  of  the  audit 
is  primarily  to  see  that  the  property  called  for  by  the 
books  is  on  hand  at  the  end  of  the  period,  and  since 
it  is  in  most  cases  impossible  for  both  parts  of  the 
examination — namely,  the  conclusions  from  the 
books  and  the  counting  of  property — to  be  performed 
at  one  sitting,  the  auditor  must  take  precautions  that 
no  changes  shall  be  made  in  either  the  books  or  the 
property  while  the  audit  is  in  progress.  The  whole 
art  of  auditing  with  respect  to  property  is  so  to  con- 
duct the  work  that  the  conclusions  from  the  books 
and  the  counting  of  property  shall  be  brought  to  a 
culmination  at  the  same  moment,  and  that,  there- 

A  &  A-26 


4m  ACCOTTNTING  AKD  AUBITINa 

fore,  no  doctoring  of  either  shall  be  possible.  The 
auditor  must  therefore  know  and  preclude  the  possi- 
bilities of  making  changes  in  the  books  to  represent 
what  is  not  a  fact,  and  of  padding  the  assets  so  that 
they  shall  appear  to  be  greater  than  they  really  are. 
He  must  conduct  his  work  in  such  a  way  that  no 
loopholes  shall  be  left  and  that  at  all  times  the  work 
which  he  has  performed  lies  under  his  own  hand  and 
cannot  be  changed  without  discovery. 

An  important  medium  for  helping  the  auditor  to 
make  sure  that  the  accounts  have  not  been  altered 
during  the  progress  of  the  examination  is  a  note- 
book in  which  memoranda  of  important  figures  may 
be  made.  Since  it  is  important  at  some  definite  mo- 
ment to  see  that  the  property  on  hand  agrees  with 
that  called  for  by  the  books,  and  yet  one  cannot 
usually  go  through  all  the  books  at  one  sitting,  the 
only  precaution  against  interference  with  the  books 
lies  in  making  a  memorandum,  on  outside  papers,  of 
the  total  of  the  books,  so  that  a  comparison  with  the 
originals  at  any  time  in  the  later  progress  of  the 
audit  will  show  whether  changes  have  been  made. 
These  working  papers  constitute  virtually  another 
set  of  books  written  up  under  the  auditor's  own  di- 
rection, but  containing  only  summaries  of  important 
details.  The  specific  items  to  be  entered  in  such 
working  papers  will  be  considered  in  connection  with 
the  separate  steps  of  an  audit. 

It  is  foolish  for  anyone  to  attempt  to  audit  books 
until  he  has  become  familiar  with  the  ordinary  opera- 
tions of  the  business,  with  the  books  which  are  ordi- 
narily kept,  and  with  the  system  of  organization 
which  determines  who  is  responsible  for  all  entries. 


AtJDITING  403 

The  first  step,  therefore,  is  for  the  auditor  to  look 
over  the  business  carefully  and  see  just  what  is  done. 
The  second  is  to  leam  just  what  books  are  kept  and 
what  each  book  is  designed  to  do.  The  third  is  to 
leam  who  is  responsible  for  the  entries  in  all  books. 
With  this  information  at  hand  the  auditor  may  plan 
the  course  of  his  audit  and  know  all  the  time  what 
materials  he  has  at  hand  and  what  loopholes  have 
been  left  for  errors  of  carelessness  or  of  fraud.  It  is 
worth  while  to  spend  a  large  amount  of  time  in  study- 
ing the  situation  before  attempting  any  handling  of 
the  direct  figures;  for  when  one  has  become  engaged 
in  the  handling  of  books  and  the  checking  of  figures 
one  is  likely  to  be  so  much  impressed  with  the  imme- 
diate task  in  hand  that  one  forgets  the  larger  aspects 
and  may  fail  to  see  a  loophole  in  the  general  system. 
One  should  note  not  only  what  books  are  actually 
kept,  but  whether  any  book  which  is  necessary  to 
make  a  secure  plan  of  accounting  has  been  omitted, 
or  whether  any  person  is  left  in  charge  of  two  books 
which  ought  to  be  so  thoroughly  separated  that  one 
can  be  used  as  a  check  on  the  other.    ^ 

Ordinarily  the  first  step  in  the  actual  audit  is  to 
transcribe  on  one's  working  papers  the  summary  of 
all  transactions.  The  most  serviceable  form  for  this 
is  usually,  of  course,  the  trial  balance.  This  trial  bal- 
ance should  be  copied  item  for  item  into  the  working 
papers,  and  if  this  is  a  first  audit  the  trial  balance  at 
the  beginning  of  the  period  audited  should  also  be 
taken  in  order  that  without  reference  to  the  books 
themselves  the  auditor  can  see  what  should  be  the 
net  changes  for  the  period  under  examination.  If 
this  is  a  second  or  later  audit  by  the  same  auditor,  he 


404  ACCOUNTING  AND  AUDITING 

should  use  as  his  initial  trial  balance  the  copy  he 
took  at  the  close  of  the  last  period  audited.  If  the 
trial  balance  includes,  as  it  usually  does,  some  con- 
trolling accounts — that  is,  accounts  representing,  in 
the  general  ledger,  groups  of  accounts  in  subordinate 
ledgers — the  audit  cannot  be  complete  unless  a  list 
is  made  of  all  balances  shown  on  the  subordinate 
ledgers,  for  otherwise  the  auditor  leaves  open  to  the 
bookkeeper  the  opportunity  to  make  changes  in  the 
subordinate  ledgers  during  the  course  of  the  audit. 
If,  on  the  other  hand,  the  auditor  has  a  complete  trial 
balance  with  a  separate  list  (which,  of  course,  must 
agree  with  the  balance  of  the  corresponding  con- 
trolling account  in  the  general  ledger)  of  individual 
accounts,  he  has  the  whole  condition  of  the  business 
as  represented  by  the  books  in  his  own  hands,  and 
no  changes  made  later  can  escape  him  if  he  uses  due 
diligence.  It  is  well  to  add  to  these  figures,  how- 
ever, the  monthly  totals  of  all  books  posted  in  lump 
sums — such  as  the  cash  book,  the  purchase  book,  and 
the  sales  book. 

The  next  step  is  for  the  auditor  to  examine  the 
property  on  hand  at  the  close  of  the  period.  In  gen- 
eral, this  property  should  be  listed  on  the  working 
papers,  for  in  a  large  business  anyone  having  charge 
of  property  may  with  fraudulent  intention  present 
some  property  twice  unless  the  auditor  is  careful  to 
list  or  mark  for  identification  each  bit  as  he  passes  it. 
A  common  method  is  to  stamp  or  check  by  some  pri- 
vate mark  each  evidence  of  property  passing  through 
the  auditor's  hands.  If  such  property  is  also  listed, 
there  is  little  danger  that  any  shall  be  counted  twice. 
It  is  usually  possible  to  copy  the  trial  balance,  to 


AUDITING  405 

copy  the  balances  of  subordinate  ledger  accounts, 
and  to  count  the  property,  at  one  sitting — though,  of 
course,  many  clerks  may  be  needed  to  put  through  all 
this  in  one  day.  When  this  cannot  be  done  the  audi- 
tor should  keep  within  his  control  all  matters  on 
which  the  examination  is  not  completed.  Then  as 
he  has  knowledge  of  the  results  of  all  transactions — 
in  his  summary  of  the  books  and  of  the  property — 
he  may  begin  in  the  ordinary  course  to  examine  spe- 
cific items  and  learn  whether  the  details  as  shown  by 
the  books  produce  the  summary  of  the  situation  as 
recorded  in  his  own  working  papers.  To  that 
examination  we  will  now  proceed. 

It  is  well  before  we  attempt  to  find  means  of  pro- 
tection against  fraud  to  note  what  are  the  commonest 
devices  for  covering  fraud;  for  some  sorts  of  fraud 
may  be  perpetrated  through  several  different  books, 
and  after  we  have  once  grasped  the  principle  we  can 
follow  through  the  checks  in  the  various  books  with- 
out repeating  our  discussion  of  the  fraud  which  they 
are  intended  to  detect.  Let  us  take,  first,  frauds 
attempted  by  subordinates  against  the  orders  of  their 
superiors. 

As  has  already  been  suggested,  most  fraud  is  at- 
tempted in  connection  with  cash.  The  most  obvious 
scheme  of  this  sort  is  to  report  cash  receipts  to  be 
less  than  the  actual  amount  received,  and  thus  leave 
a  sum  to  be  appropriated  by  the  cashier.  Always, 
of  course,  the  bookkeeper  realizes  the  possibility  that 
the  payments  of  cash  will  later  be  discovered  and 
that  then  the  discrepancy  will  appear.  His  decep- 
tive task  is  so  to  make  his  entries  that  the  pajTnent 
will  be  recorded  as  a  credit  to  the  person  paying,  but 


406  ACCOUNTING  AND  AUDITING 

Hot  the  receipt  as  a  debit  to  Cash.  In  the  natural 
course  of  events,  if  f br  a  cash  receipt  the  personal  ac- 
count is  credited  and  no  debit  of  any  kind  is  given,  a 
discrepancy  appears  in  the  trial  balance;  but  if  the 
precaution  is  taken  to  reduce  the  credit  balance  (or 
increase  the  debit  balance)  of  some  other  account  on 
the  subordinate  ledger,  so  that  the  total  balances 
shall  still  agree  with  the  balance  on  the  controlling 
account  in  the  general  ledger,  no  discrepancy  will  ap- 
pear unless  the  falsified  account  chances  to  receive 
careful  examination.  This  device  has  been  com- 
monly used  by  defaulting  bookkeepers  who  knew 
which  accounts  were  little  likely  to  be  questioned. 
In  such  a  case,  of  course,  the  bookkeeper  is  careful  in 
sending  a  statement  to  the  customer  falsely  debited 
to  include  only  the  correct  figure.  By  this  device  the 
books  are  kept  in  balance,  the  proper  credit  is  given 
to  the  customer  paying  the  bill,  and,  instead  of  a  debit 
to  Cash,  the  books  show  a  false  debit  to  another  cus- 
tomer. If  the  bookkeeper  can  at  his  convenience 
shift  this  false  debit  so  as  to  keep  it  constantly  in  a 
quiescent  state,  the  trick  may  escape  detection. 
Only  the  customer's  verification  of  his  balance  as 
shown  by  the  books  of  the  firm  will  detect  false  en- 
tries if  they  are  made  skilfully.  Sometimes  al)Ook- 
keeper  produces  the  desired  credit  to  a  customer's 
account,  without  debiting  Cash,  by  treating  the  pay- 
ment as  if  it  were  an  allowance  for  returned  goods  or 
for  discounts;  thwi  he  may  appropriate  the  cash 
without  throwing  the  books  out  of  balance.  If  the 
bookkeeper  is  left  a  free  hand  in  charging  off  cus- 
tomers' accounts  to  Bad  Debts,  moreover,  it  lies 
within  his  power  at  any  time  to  put  remittances  into 


AUDITING  407 

his  own  pocket  and  close  a  customer's  account  as  if 
it  had  proved  worthless — provided,  as  should  never 
happen,  he  has  not  only  the  handling  of  the  books  but 
also  the  handling  of  remittances.  All  these  devices 
show  the  correct  balance  for  the  remitting  customer's 
account,  and  therefore  are  little  likely  to  be  detected 
through  the  customer  himself. 

Another  method  of  diverting  cash  to  the  pockets 
of  the  bookkeeper  or  cashier  is  to  credit  Cash  for 
larger  payments  than  are  actually  made.  Unless  the 
business  is  closely  watched,  this  can  be  done  by  debit- 
ing creditors  for  the  full  face  of  bills  even  when  dis- 
counts were  taken  or  goods  were  returned.  The 
difference  between  the  net  price  paid  and  the  gross 
price  entered  on  the  bills  is  set  free  for  the  cashier's 
pocket,  and  no  discrepancy  is  shown  in  either  the 
cash  account  or  the  account  of  the  customer  imless 
the  details  of  the  customer's  account  are  passed 
upon. 

If  the  bookkeeper  and  cashier  are  left  a  free  hand 
for  the  payment  of  interest,  taxes,  insiu'ance,  etc., 
they  may  represent  payments  to  be  larger  than  the 
actual  amount  called  for  and  divert  the  excess  to 
their  own  pockets.  It  is  possible,  indeed,  that,  un- 
less the  transactions  are  watched  carefully,  a  creditor 
may  be  debited  a  second  time  for  a  bill  paid  once,  and 
the  second  payment  be  diverted  to  the  cashier's  own 
use, — provided  only  some  other  account  is  falsely 
debited  at  the  time  of  the  entry  to  the  credit  of  Cash. 
If  a  debit  is  made  to  another  customer,  the  books  will 
show  no  discrepancy  between  debits  and  credits,  and 
the  only  precaution  the  bookkeeper  needs  to  take  in 
covering  his  tracks  is  that  the  false  amount  be  trans- 


408  ACCOUNTING  AND  AUDITING 

ferred  to  some  other  account  before  this  account 
chances  to  be  examined.  Many  bank  defalcations 
have  been  continued  for  years  because  they  were 
hidden  in  unquestioned  balances  in  so-called  inactive 
accounts. 

A  device  which  has  been  used  many  times  to  cover 
defalcations  is  borrowing  from  the  future  through 
remittances  received  in  the  daily  course  of  business. 
If,  for  instance,  a  cashier  receives  daily  large  sums 
of  money,  he  may  fail  to  enter  those  sums  on  the 
books  for  perhaps  twenty-four  hours,  and  may  use 
part  of  them  to  cover  a  defalcation  of  the  past;  and 
he  knows  that  he  will  have  at  his  disposal  among  the 
remittances  of  tomorrow  enough  to  cover  the  short- 
age of  today.  So  long  as  the  books  are  never  quite 
written  up  to  date,  the  cashier  has  at  his  disposal,  if 
the  business  is  so  organized  as  to  give  him  access 
both  to  money  and  to  the  books,  a  sum  which  has  not 
up  to  that  time  been  recorded. 

The  detection  of  forgery  is  not  here  considered  as 
properly  within  the  auditor's  function;  but,  of 
course,  if  he  has  reason  to  suspect  crookedness,  he 
should  be  on  the  lookout  for  anything  which  should 
lead  to  its  discovery. 

We  may  now  turn  to  errors  of  fraud  committed 
by  officers.  Among  the  common  devices  to  misrep- 
resent the  condition  of  a  business  is  the  inclusion  of 
bad  debts  and  bad  bills  receivable  as  good.  Some- 
times a  manager  fails  to  report  the  issue  of  notes 
which  are  still  outstanding,  even  though  these  notes 
were  issued  for  cash.  The  failure  to  credit  Bills  Pay- 
able in  such  a  case  is  covered  by  a  credit  to  some 
other  account  that  in  the  nature  of  the  case  is  not 


AUDITING  409 

examined  in  detail  in  the  ordinary  course  of  business. 
It  may  happen  that  a  considerable  loss  is  hidden  by 
a  failure  to  record  on  the  books  the  fact  that  notes 
received  from  customers  have  been  discounted  at 
banks,  and  that  these  notes  have  not  been  paid  at 
maturity;  for  in  that  case  the  business  is  liable  for 
their  payment,  and  yet,  if  Bills  Receivable,  instead 
of  Bills  Discounted,  was  credited  at  the  time  the 
notes  were  discounted,  nothing  on  the  books  will 
show  that  the  business  is  liable  unless  a  new  entry 
has  been  made  at  the  time  of  maturity  debiting  Pro- 
tested Notes  and  crediting  the  former  holder  of  the 
notes.  Through  neglect  of  this  entry  liabilities  may 
be  represented  as  less  than  they  really  are. 

If  the  accounting  is  not  careful,  goods  received 
just  before  the  time  of  taking  account  of  stock  may 
be  counted  in  the  inventorv  before  thev  have  been 
entered  on  the  books.  In  such  a  case  the  profits  of 
the  business  and  the  net  assets  will  be  misrepre- 
sented; for  merchandise  will  not  have  been  debited, 
and  yet  the  inventory  will  be  treated  as  a  quasi 
credit. 

With  this  preliminary  survey  of  the  frauds  likely 
to  be  attempted,  let  us  turn  to  the  methods  of  ex- 
amination. A  few  general  rules  should  be  held  con- 
stantly in  mind.  Alterations  and  corrections  should 
receive  careful  scrutiny,  for  they  may  have  arisen 
from  an  attempt  to  correct  an  error  or  to  hide  a 
fraud;  and  not  always  does  a  bookkeeper  get  the  cor- 
rect result  when  he  is  trying  honestly  to  correct  an 
error.  It  is  extremely  easy  in  making  corrections  to 
commit  a  new  error.  Ambiguous  figures — that  is,  fig- 
ures which  are  not  perfectly  clear  to  read — should  be 


410  ACCOUNTING  AND  AUDITING 

given  careful  attention,  especially  when  carried  to 
another  book;  for  a  figure  which  the  bookkeeper 
meant  for  ^^7"  may  have  been  added  or  posted  as  a 
*^1"  or  a  *^9."  In  checking  figures,  care  must  be 
taken  to  avoid  confusion  of  dollars  and  cents.  Even 
a  person  checking  by  the  eye  is  usually  influenced 
unconsciously  by  the  imaginary  sound  of  the  figures, 
so  that  if  he  reads  '^117.00,"  he  may  check  ^^1.17"; 
or  he  may  check  200.25  as  225.00.  The  word  ^'dol- 
lars'' or  *' point"  should  always  be  used;  then  the 
expression  wiU  be  ''one  hundred  seventeen  point" 
or  "two  hundred  dollars  twenty-five."  This  is  espe- 
cially necessary  when  one  person  is  calling  off  to  an- 
other who  does  not  see  the  original  figures.  The 
auditor  must  be  sure  that  he  understands  exactly  the 
purpose  and  use  of  every  special  column  in  every 
book,  for  if  a  column  is  designed  for  one  use,  and 
then  fraudulently  or  carelessly  put  to  another,  it  is 
the  auditor's  business  to  detect  the  misrepresenta- 
tion. 

Before  we  study  in  detail  each  of  the  separate 
books  and  separate  kinds  of  entries,  it  is  worth  our 
while  to  examine  the  various  auditing  processes 
which  must  be  used.  In  the  following  pages  will  be 
found  a  summary  statement  of  the  principal  work 
to  be  performed  in  each  book,  and  it  will  be  a  saving 
of  time  and  space  if  in  many  cases  we  use  terms 
which  are  more  or  less  technical  or  even  if  we  manu- 
facture terms  to  indicate  processes  which  have  no 
special  name.  Let  us  see  what  is  the  nature  of  each 
of  the  common  processes  and  what  terms  we  shall 
hereafter  apply  to  them. 
■  Wherever  possible  an  entry  should  be  compared 


AUDITING  411 

with  the  original  document  which  gave  rise  to  it, — 
for  instance,  a  credit  for  goods  purchased  should  be 
compared  with  the  original  bill.  Whenever  in  the 
following  pages  the  word  '^verify"  is  used  in  con- 
nection with  any  book,  it  will  mean  that  the  items 
there  shown  are  to  be  compared  with  the  original 
documents. 

All  payments  should  be  compared  with  the  re- 
ceipts for  payment.  Such  receipts,  whether  they  are 
endorsements  on  returned  checks  or  are  formal  re- 
ceipted bills,  are  called  '^vouchers."  A  receipted 
bill  is  a  better  voucher  than  an  endorsed  check,  for  it 
shows  not  only  how  much  money  was  paid  but  what 
it  was  paid  for.  Sometimes  a  check  given  for  one 
payment  is  fraudulently  offered,  when  endorsed  and 
paid,  as  voucher  for  another. 

Sometimes  no  original  document  or  voucher  can 
be  had,  and  then  it  will  be  necessary  to  consult  origi- 
nal records  which  may  be  in  auxiliary  books;  for  in- 
stance, since  the  actual  shipment  of  all  goods  is  sup- 
posed to  be  entered  on  a  shipping  book,  sales  should 
be  shown  there.  Freight  and  express  receipts 
should  be  preserved  to  show  that  shipment  was 
made;  such  receipts  do  not  usually  show  more  than 
the  number  and  kind  of  packages,  however.  When- 
ever an  entry  is  supported  by  the  evidence  of  such  an 
auxiliary  book,  it  may  be  said  to  be  '* confirmed.'' 

In  order  to  make  sure  that  some  account  was  deb- 
ited for  every  credit,  and  vice  versa,  especially  in 
connection  with  books  posted  in  totals — such  as  the 
purchase  book  and  the  sales  book, — the  auditor 
should  go  over  all  footings. 

Whenever  a  book  contains  several  columns  so 


il2  ACCOUNTING  AND  AUDITING 

used  that  each  of  them  is  footed  and  posted  on  one 
side  and  the  total  of  the  various  columns  is  posted  on 
the  other  side,  footing  should  be  performed  not  only 
vertically  for  each  column,  but  also  horizontally  so 
as  to  make  sure  that  the  grand  total  agrees  with  the 
sum  posted.    This  is  called  ^* cross  footing." 

Whenever  a  book  has  special  columns  for  differ- 
ent accounts,  like  the  special-column  cash  book,  the 
auditor  should  examine  the  extensions  to  see  that  the 
amounts  stand  debited  or  credited  to  the  proper  ac- 
counts and  in  the  proper  columns.  This  is  examin- 
ing the  ** distribution." 

Of  course,  all  items  appearing  in  books  of  original 
entry  must  go  ultimately  to  some  ledger.  It  is  not 
always  necessary  that  postings  to  the  subordinate 
ledgers  shall  be  examined,  for  the  controlling  ac- 
counts in  the  general  ledger  show  what  should  be  the 
total  debits  and  credits  to  the  subordinate  ledger,  and 
if  the  total  is  found  to  agree  the  individual  postings 
may  be  assumed  correct, — at  least  if  the  tests  to  be 
described  later  are  applied.  All  postings  to  the  gen- 
eral ledger,  however,  should  be  examined.  At  the 
time  of  examination  they  should  be  ^* checked" — that 
is,  actually  marked  both  in  the  book  of  original  entry 
and  in  the  ledger.  The  check  should  be  of  a  sort  to 
distinguish  it  from  checks  made  during  the  ordinary 
progress  of  bookkeeping.  An  auditor  should  never 
give  a  second  posting  check  to  any  item,  or  pass  it  if 
once  checked,  under  any  circumstances;  for,  though 
the  assumption  may  be  that  it  was  checked  the  first 
time  by  mistake,  there  is  an  equally  good  assumption 
that  it  was  checked  in  error  for  some  other  item,  and 
that,  therefore,  the  other  item  will  remain  unchecked. 


AUDITING  413 

If,  therefore,  in  the  course  of  checking,  an  item  once 
checked  is  about  to  be  checked  again,  note  should  be 
made  of  the  fact  so  that  when  the  books  are  gone 
through  finally,  to  see  whether  any  items  are  still 
unchecked,  the  cause  of  error  can  be  discovered. 

When  all  posting  is  thought  to  have  been  exam- 
ined, error  may  still  persist  unless  the  auditor  goes 
through  all  the  books  to  see  that  no  item  remains  in 
any  book  unchecked;  for  since  checking  is  bound  to 
be  more  or  less  wandering,  from  one  book  to  another, 
some  items  may  chance  to  be  overlooked  at  first.  It 
may  sometimes  happen  that  an  item  remains  un- 
checked in  the  ledger  or  in  some  other  book  because 
of  peculiar  circumstances  which  do  not  appear  at 
first  glance.  On  the  discovery  of  such  an  item  the 
entry  should  be  copied,  on  the  auditor's  working 
papers,  with  full  information.  If  books  are  kept  by 
double  entry,  an  unchecked  item  is  sure  to  throw  the 
books  out  of  balance  unless  it  is  offset  by  some  other 
unchecked  item  on  the  other  side.  If  such  another 
is  found  and  they  cannot  be  explained  so  that  their 
meaning  is  beyond  question  and  is  clearly  legitimate, 
they  should  be  reported.  If,  on  the  other  hand,  no 
mate  to  an  unexplained  posting  can  be  found,  the 
auditor  should  discover  why  it  does  not  throw  out  the 
trial  balance;  if  it  is  an  obvious  error  he  should  have 
it  corrected,  and  if  it  looks  suspicious  he  should  call 
attention  to  it  in  his  final  report. 

Sometimes  an  auditor  may  be  unable  to  pass  upon 
an  item  even  though  the  bookkeeping  is  entirely 
regular,  for  sometimes  a  transaction  is  of  so  peculiar 
a  nature  that  it  is  beyond  his  power  to  interpret  and 
he  is  unable  to  get  from  any  officer  an  explanation 


414     ^  ACCOUISTTHSTG  AND  AUDITING 

which  seems  to  him  to  justify  him  in  passing  it  with- 
out further  question.  In  such  a  case  he  should  make 
a  memorandum  of  the  item  in  detail  and  report  it  to 
his  clients.  He  may  well  call  attention  in  his  report, 
moreover,  to  explanations  offered  him,  and  give  the 
name  of  the  officers  offering  them  and  the  date  when 
they  were  offered. 

It  is  an  auditor's  business  to  make  sure,  after  he 
has  checked  original  entries  into  the  ledger,  that  the 
balances  standing  on  the  ledger,  and,  therefore,  re- 
ported on  the  trial  balance  and  the  balance  sheet,  cor- 
rectly represent  the  ledger  figures.  He  must,  there- 
fore, figure  the  ledger  balances  and  compare  them 
with  the  trial  balance.  This  is  '^verifying"  balances 
and  the  trial  balance. 

An  auditor  should  always  make  sure  that  a  con- 
trolling account  in  the  general  ledger  agrees  with  the 
balance  of  accounts  in  the  corresponding  subordi- 
nate ledger,  and  he  should  learn  this  for  himself  by 
figuring  the  balances  on  all  subordinate  ledgers  and 
making  the  comparison. 

It  is  obvious  that  a  dishonest  clerk  could  on  the 
sales  books  extend  debits  to  customers  for  less  than 
the  actual  amount  of  the  sales,  and  then,  if  he  also 
had  the  handling  of  the  cash,  could  divert  to  his  own 
use  the  difference  between  the  amount  of  payment 
when  the  bill  was  actually  paid  and  the  amount 
standing  on  the  books.  If  no  system  of  internal 
check  is  provided  to  preclude  this,  the  auditor 
should  see  that  extensions  are  properly  made.  It  is 
not,  however,  his  duty  to  compare  prices  entered  on 
bills  with  ^-he  actual  selling  price;  for  he  has  the  right 


AUDITIIsrG  415 

to  assume  that  at  least  this  much  is  done  by  someone 
in  authority  within  the  business  itself. 

Sometimes  it  is  necessary  for  an  auditor  to  follow 
an  item  from  an  auxiliary  book  into  a  book  of  origi- 
nal entry  so  as  to  make  sure  that  part  of  the  property 
of  the  business  has  not  disappeared  without  due  debit 
to  some  personal  account.  This  should  be  done  for 
the  shipping  book,  for  instance.  This  is  called 
**  tracing." 

Let  us  now  turn  to  the  specific  books.  It  is  cus- 
tomary to  begin  an  examination  with  the  cash  book, 
for  as  this  is  the  most  general  book  it  soonest  gives 
the  auditor  a  grasp  of  the  business  under  examina- 
tion. The  first  step  is  to  draw  off  a  summary  of  the 
cash  book  by  months  for  the  period  under  review. 
For  each  month  there  should  be  taken  the  balance  at 
the  beginning,  the  total  debits,  the  total  credits,  and 
the  resulting  balance  at  the  close.  Next,  the  auditor 
should  do  the  same  for  the  check  book — or  the  com- 
bined result  for  all  the  check  books  if  more  than  one 
is  in  use, — that  is,  the  balance  at  the  beginning,  the 
deposits,  the  withdrawals,  and  the  balance  at  the 
close.  Finally,  the  same  sort  of  thing  should  be  done 
for  the  bank  pass  book, — that  is,  the  opening  balance, 
the  deposits,  the  checks  returned,  and  the  closing 
balance. 

It  is  obvious  that  these  three  books  will  not  neces- 
sarily agree,  for  very  often  checks  will  not  be  drawn 
for  all  payments,  not  all  receipts  will  have  been  im- 
mediately deposited,  and  not  all  checks  drawn  will 
necessarily  have  been  presented  at  the  bank  before 
the  pass  book  is  balanced.   It  is  necessary,  therefore. 


416  ACCOUNTHsTG  AND  AUDITING 

that  these  three  statements  shall  be  reconciled — that 
is,  that  a  statement  shall  be  drawn  up  for  each  month 
showing  what  items  appearing  in  any  one  of  these 
books  have  not  yet  appeared  on  the  others.  It  might 
seem  at  first  as  if  the  only  thing  necessary  for  the 
audit  is  to  make  a  reconciliation  for  the  end  of  the 
period  under  audit;  for  of  course  if  things  are  cor- 
rect at  the  end  of  the  time  they  are  presumably  cor- 
rect in  the  intervening  months.  This  would  be  true 
if  one  could  be  absolutely  sure  that  no  fraud  had  been 
committed;  but  since  a  discrepancy  in  some  months 
might  be  made  up  in  later  months,  and  some  person 
having  control  of  cash  might  have  been  using  funds 
of  the  business  for  his  own  purposes  in  the  interim, 
it  is  desirable  to  see  for  each  month  just  what  are 
the  differences  among  these  three  books.  In  making 
this  reconciliation  it  is  necessary  to  examine  the 
checks  returned  by  the  bank  as  paid;  and  since  it  is 
necessary  also  to  use  these  same  checks  as  vouchers 
for  cash  payments,  it  is  well,  so  far  as  possible,  to 
perform  the  two  operations  at  once.  It  is  likely  to  be 
worth  while,  therefore,  to  compare  checks  with  the 
cash  book  entries  before  undertaking  the  final  recon- 
ciliation between  the  check  book,  the  pass  book,  and 
the  cash  book.  We  will  proceed,  therefore,  to  com- 
pare checks  with  the  cash  book  credit  entries. 

As  has  already  been  suggested,  it  is  desirable  that 
all  payments  of  cash  which  are  to  be  entered  on  the 
primary  cash  book  shall  be  made  through  the  me- 
dium of  checks;  if  any  payments  and  receipts  are 
made  in  currency,  they  may  be  entered  preferably  on 
the  petty  cash  book.  If  that  is  done,  the  checks  re- 
turned by  the  bank  as  paid  should  agree  exactly,  ex- 


AUDITING  417 

cept  so  far  as  any  checks  are  outstanding,  with  the 
cash  book  credit  items.  This  makes  comparatively 
simple  the  task  of  reconciliation.  When  currency 
as  well  as  checks  is  entered  on  the  cash  book,  two 
kinds  of  cash  must  be  considered  in  making  the 
reconciliations.  It  is  desirable  in  that  case  to  tick  in 
the  cash  book  all  payments  by  check  when  they  are 
found  to  agree  with  checks  returned  by  the  bank. 
This  is  not  a  laborious  task  if  the  auditor  takes  the 
returned  checks  in  consecutive  order  and  compares 
them  with  the  cash  book  credits,  checking  the  cash 
book  as  he  goes  along.  The  order  is  necessarily  the 
same  for  both  checks  and  entries,  of  course.  It  is 
not  enough,  however,  for  the  auditor  to  see  that  the 
amounts  of  checks  agree  with  cash  book  credits;  he 
must  also  note  whether  the  payees  of  the  checks  and 
the  endorsers  are  the  same  as  the  persons  indicated 
in  the  cash  book  entries  as  the  proper  recipients  of 
the  money;  for  one  method  of  fraud  is  to  debit  a 
check  on  the  books  to  the  proper  account,  but  to  make 
out  the  check  to  the  wrong  payee — for  the  benefit  of 
the  defaulting  employee.  Such  an  operation  would 
not  be  disclosed  by  any  error  in  the  books  except  as 
the  balances  of  the  accounts  concerned  might  chance 
to  be  investigated.  If  the  cash  book  is  kept  so  that 
discounts  are  entered  contra — that  is,  on  the  oppo- 
site side, — the  auditor  should  look  to  see  that  the 
amount  of  discount  is  entered  on  the  receipts  side  of 
the  cash  book  so  as  to  produce  a  net  credit  to  cash 
of  only  the  amount  actually  paid  as  shown  by  the 
returned  check. 

So  far  om*  examination  of  the  cash  book  has  been 
for  the  purpose  of  learning  whether  the  checks  re- 

A  &  A-27 


418  ^lCCOUISTTING  AND  AUDITING 

turned  show  that  the  cash  book  entries  faithfully 
record  actual  payments.  We  may  postpone  until 
later  the  examination  of  the  justification  for  those 
actual  payments. 

When  all  payments  by  check  have  been  in  this 
fashion  examined,  and  the  checks  themselves  stand 
as  accepted  vouchers,  the  task  of  direct  reconciliation 
with  the  check  book  and  the  pass  book  may  begin. 
One  source  of  difference  is  the  fact  that  the  cash  book 
may  contain  currency  payments  which  are  not,  of 
course,  on  the  check  book  or  the  pass  book.  Again, 
checks  which  have  not  yet  been  presented  at  the  bank 
for  payment  will  appear  on  the  cash  book  and  the 
check  book  but  not  on  the  pass  book.  Finally,  checks 
drawn  in  the  previous  month,  but  not  during  that 
month  presented  for  payment  at  the  bank,  but  pre- 
sented during  the  current  month,  will  be  on  the  pass 
book  but  not,  of  course,  among  this  month's  items  of 
the  cash  book  and  the  check  book.  The  reconcili- 
ation among  these  books  may  be  provided  by  arrang- 
ing a  table  with  a  column  for  each  book  and  a  hori- 
zontal line  for  each  separate  item  on  any  book.  Then 
the  first  column  mav  be  for  the  cash  book,  the  second 
for  the  check  book,  and  the  third  for  the  pass  book. 
If  the  first  line  is  meant  to  contain  payments,  in  the 
cash-book  column  will  be  the  total  credits;  in  the 
check-book  column,  the  checks  drawn;  and,  in  the 
pass-book  column,  the  checks  charged  against  the 
business  by  the  bank.  These  are  likely,  for  the  rea- 
sons already  given,  to  fail  of  agreement.  If,  now,  we 
add  in  red  ink  in  the  column  for  each  book  the  items 
omitted  from  that  book  but  contained  in  the  other 
books,  the  totals  of  the  three  colmnns  should  agree. 


AUDITING  419 

Thus,  currency  paid  is  included  in  the  cash  book 
credits,  but  since  it  is  not  on  the.  check  book  and  the 
pass  book  it  is  inserted  in  those  columns  in  red  ink. 
This  month's  checks  not  yet  paid  by  the  bank  are  on 
the  cash  book  and  the  check  book,  but  are  not  on  the 
pass  book,  and,  therefore,  should  be  extended  in  red 
ink  in  the  pass-book  column.  Checks  entered  in  the 
cash  book  and  the  check  book  last  month  but  only 
this  month  charged  by  the  bank  on  the  pass  book 
will  be  entered  in  the  cash-book  column  and  the 
check-book  column,  because  this  amount  is  necessary 
to  put  the  other  books  on  a  basis  with  the  pass  book. 
An  illustration  of  such  a  reconciliation  is  given 
below. 


Disbursements 
Currency  items 
Cheeks  outstanding 
Checks  of  previous  months 

Cash  Book 
$27,201.25 

Check  Book 

$27,154.37 

46.88 

Pass  Book 

$27,004.37 

46.88 

1,117.50 

967.50 

967.50 

$28,168.75  $28,168.75  $28,168.75 


As  this  reconciliation  is  prepared  for  each  month 
the  auditor  should  make  a  list  of  all  differences  ap- 
pearing in  that  month, — that  is,  for  example,  list  all 
checks  entered  in  the  check  book  not  in  that  month 
returned  by  the  bank.  When  these  items  appear 
later,  they  may  be  checked  on  that  list,  and  thus  he 
will  know  whether/ all  discrepancies  are  accounted 
for;  any  not  accounted  for  by  the  reconciliations  need 
further  examination.  It  is  difficult  to  exaggerate 
the  value  of  such  lists.  It  seems  to  the  novice  as  if 
time  spent  in  making  lists  of  things  which  ultimately 
are  to  be  cancelled  is  to  great  extent  a  waste.  This 
would  be  true  if  one  could  always  know  that  the 


420  ACCOUNTING  AND  AUDITING 

items  would  be  later  cancelled;  but  since  the  purpose 
of  an  audit  is  to  make  sure  that  everything  is  prop- 
erly provided  for,  any  time  spent  in  making  such  lists 
is  nothing  less  than  an  ultimate  saving.  Such  lists, 
moreover,  should  be  given  a  very  clear  title;  a  list  of 
which  the  purpose  is  not  clear  is  sometimes  worse 
than  no  list  at  all,  for  sometimes  to  find  out  just  what 
it  is  designed  to  do  takes  longer  than  constructing  a 
new  list.  Many  a  bookkeeper  has  spent  fruitless 
hours  in  hunting  for  memoranda  which  were  not 
properly  labeled,  or  in  trying  to  find  the  exact  use  of 
memoranda  at  hand. 

When  this  reconciliation  of  cash  book,  check  book, 
and  pass  book  has  been  completed  for  disbursements, 
and  a  list  made  of  all  unexplained  discrepancies,  the 
auditor  should  turn  his  attention  to  the  receipts  side 
of  cash.  He  should  see  that  all  receipts  have  been 
accounted  for,  month  by  month.  A  reconciliation  is 
necessary.  The  differences  among  the  three  books 
are  likely  to  be  mainly  items  on  the  cash  book  which 
have  not  yet  been  deposited  (particularly  receipts  of 
the  last  day  of  the  month  after  the  customary  hour 
for  making  deposits),  and,  if  the  custom  does  not 
prevail  in  that  business  of  making  all  payments 
through  the  bank,  a  working  balance  of  cash  in  the 
cash  drawer.  The  check  book  should  contain  few 
deposits  that  are  not  in  the  cash  book  for  that  month ; 
but  the  pass  book  may  contain  interest  on  deposits, 
if  any  is  allowed  by  the  bank,  and  this  will  be  in 
excess  of  amounts  shown  in  the  cash  book  and  the 
check  book  for  that  month.  A  reconciliation  form  is 
shown  below. 


AUDITING  .  421 

Cash  Book  Check  Book  Pass  Book 

Eeceipts                                                    $23,210.27  $23,318.43  $23,328.73 

Receipts  not  deposited                           109.10  109.10 

Deposit  of  previous  month's  receipts        217.26         

Interest  on  bank  balances                             10.30  10.30         


$23,437.83         $23,437.83         $23,437.83 


The  auditor  should  watch  deposits  with  extreme 
care.  He  should  recommend  that  whenever  a  de- 
posit is  made  a  duplicate  deposit  slip  shall  be  re- 
turned by  the  bank  with  some  sort  of  receipt;  then 
one  may  know  not  only  how  much  has  been  deposited 
each  day,  but  the  amount  of  each  separate  check. 
Many  defaulters  have  covered  their  tracks  for  long 
periods  of  time  by  borrowing  from  the  future,  as  has 
already  been  indicated;  they  borrow  today's  remit- 
tances, before  they  have  been  entered  on  the  books, 
to  cover  yesterday's  shortage;  but  though  they  have 
provided  that  the  deposits  for  each  day  correspond 
in  total  with  the  amounts  naturally  to  be  deposited, 
as  shown  by  the  cash  book,  they  are  seldom  able  to 
borrow  checks  of  just  the  same  detailed  amounts,  and 
examination  of  their  detailed  deposit  slips  would 
have  disclosed  discrepancies.  For  this  reason  it  is 
well  to  have  certified  duplicate  deposit  slips.  The 
auditor  ought,  moreover,  to  make  sure  that  the  pass 
book  presented  to  him  is  genuine,  for  defaulters  have 
sometimes  covered  their  tracks  by  presenting  for 
examination  a  pass  book  written  up  by  themselves 
and  not  corresponding  with  the  pass  book  provided 
by  the  bank.  The  auditor  should  demand  either  that 
the  pass  book  shall  be  certified  by  the  bank  or  that  he 
himself  shall  receive  the  book  in  person  from  the 
bank. 


422  ACCOUNTING  AN1>  AUDITING 

Since  an  audit  cannot  usually  be  completed  within 
two  or  three  days,  the  auditor  can  often  secure,  from 
the  bank,  checks  reported  on  his  reconciliation  as 
outstanding  at  the  time  of  beginning  the  audit. 
These  should  be  audited,  for  on  the  books  they  reduce 
the  required  cash  balance;  and  unless  the  auditor  can 
audit  them  he  has  no  assurance  that  cash  was  actu- 
ally paid  as  indicated.  It  has  happened  in  the  past 
that  defalcations  have  been  hidden  by  a  combination 
of  fraudulent  entries  of  which  a  part  were  on  the 
stubs  of  check  books,  making  things  look  as  if  checks 
had  been  drawn  and  were  outstanding  at  the  time  of 
audit.  If  an  entry  is  made  on  the  cash  book  as  if  a 
payment  were  made,  and  then  on  the  check  book  the 
bank  balance  is  reduced  (by  a  fictitious  stub),  the 
auditor  expects  to  find  the  cash  balance  by  the  books 
smaller  than  the  amount  shown  by  the  pass  book.  If 
then  the  bank  balance  is  padded  by  a  fictitious  pass 
book,  or  by  deposits  borrowed  from  the  future,  cash 
book,  check  book,  and  pass  book  agree.  This  does  not 
enable  the  cashier  to  extract  cash,  of  course ;  but  it 
does  cover  up  shortages  in  cash  previously  taken ;  for 
it  reduces  the  cash  balance,  and  appears  to  explain 
why  no  vouchers,  in  the  form  of  checks  returned  by 
the  bank,  are  at  hand  for  that  reduction.  It  substi- 
tutes an  imaginary  loss  of  cash  for  a  real  one.  Only 
a  certification  of  the  pass  book,  or  the  later  auditing 
of  outstanding  checks,  or  certified  duplicate  deposit 
slips,  can  sufiiciently  safeguard  a  business  against 
this  sort  of  thing. 

So  far  our  examination  of  the  cash  book  has  been 
for  the  purpose  of  learning  whether  the  actual  cash 
bandied  has  been  accounted  for.    We  may  now  ex- 


AUDITING  423 

amine  the  methods  of  learning  whether  the  right 
amounts  of  cash  have  been  handled.  Cash  disburse- 
ments on  notes,  bonds,  mortgages,  interest,  etc., 
should  be  compared  with  the  original  records  so  that 
one  can  be  sure  that  the  amounts  entered  are  proper, 
and  the  vouchers  should  be  examined.  Payments  for 
the  purchase  of  stocks  and  bonds  should  be  compared 
carefully  with  the  broker's  memorandum  of  pur- 
chase, for  since  the  price  of  securities  is  fluctuating 
hour  by  hour  the  possibility  of  fraud  in  that  connec- 
tion is  very  great,  and  only  when  the  amount  has 
been  vouched  by  some  responsible  person  can  it  be 
passed  by  the  auditor.  Payments  for  the  purchase 
of  real  estate  should  be  compared  with  the  deeds;  the 
memorandum  of  record  by  the  proper  recording 
official  should  be  examined, — especially  to  see  that 
the  date  is  as  it  should  be;  and  the  auditor  should  see 
that  the  title  to  the  deed  stands  in  the  name  of  the 
business  or  of  some  person  authorized  to  hold  for  the 
.business.  For  all  payments  which  require  the  vote 
of  the  directors  of  a  corporation,  the  auditor  should 
examine  the  minutes  of  the  directors'  meetings  to  see 
that  proper  authorization  was  given.  Among  such 
payments  are  those  of  dividends,  and  the  auditor 
should  see  that  the  amount  of  dividends  is  the  proper 
percentage  on  the  capital  stock.  He  should  examine 
the  dividend  books  and  dividend  checks  to  see  that 
the  proper  amounts  were  paid  to  each  stockholder; 
for  otherwise  it  might  be  possible  for  a  dishonest  em- 
ployee to  reduce  the  dividend  check  of  some  person 
not  likely  to  keep  informed  as  to  the  amount  of  divi- 
dends and  deflect  the  deficiency  to  someone  who 
would  share  the  gain  with  him.   Payments  of  salaries 


424  ACCOUNTING  AND  AUDITING 

determined  by  vote  of  directors  should  be  compared 
with  the  minutes  of  such  vote.  Payments  of  wages 
should  be  compared  with  the  pay  roll,  and  the  auditor 
should  see  that  the  pay  roll  has  been  properly  ap- 
proved by  an  officer  in  authority;  and  he  should  for 
test  purposes  compare  two  or  three  pay  rolls  in  each 
year's  work  with  the  time  books  and  thus  ascertain 
that  there  has  been  no  padding  or  carelessness  in 
determining  the  amount  for  each  employee.  Of 
course  all  entries  of  payments  for  merchandise,  sup- 
plies, etc.,  should  be  compared  with  the  original  re- 
ceipted bills  or  other  vouchers.  It  has  already  been 
suggested  that  one  method  of  deflecting  cash  to 
wrong  usage  is  to  debit  a  creditor  for  the  full  face  of 
a  bill  even  though  a  sum  smaller  (because  of  discount 
or  returned  goods)  should  have  been  paid.  It  is  the 
auditor's  business,  therefore,  whenever  payments 
have  been  made  on  items  which  may  have  been  sub- 
ject to  discount,  to  learn  whether  discounts  were 
available  on  those  payments,  and  to  see  whether,  if 
the  full  charge,  was  made,  the  creditor  has  been  deb- 
ited too  much  and  someone  has  appropriated  the 
excess.  When  the  auditor  cannot  find  vouchers  he 
should  ask  someone  in  authority  to  give  him  a  signed 
statement  as  to  the  legitimacy  of  payments.  This 
would  apply,  of  com'se,  to  petty  cash  items,  as  well  as 
to  general  items.  The  auditor  should  make  a  List  of 
all  items  which  he  cannot  properly  vouch,  and  on  that 
list  he  should  indicate  what  sort  of  voucher,  if  any, 
is  available,  and  in  what  sense  it  is  not  adequate. 
This  list  he  should  submit  to  his  clients. 

It  is  seldom  possible  to  get  adequate  vouchers  for 
cash  receipts.     Usually  the  only  thing  that  can  be 


AUDITING  425 

done  is  to  compare  the  receiptB  entered  on  the  cash 
book  with  entries  in  the  other  books  and  judge  in 
that  way  whether  the  amount  is  proper.  Since  much 
information  of  this  sort  is  got  usually  from  the 
ledger,  and  since  all  postings  ought  sooner  or  later  to 
be  checked,  it  is  well  to  combine  the  two  processes 
and  check  into  the  ledger  as  one  goes  along.  For 
pa^onents  by  customers,  for  example,  it  is  well  for 
the  auditor  to  look  up  the  customers'  accounts  in  the 
ledger  and  see  whether  the  amount  is  correct;  and 
while  he  is  engaged  in  that  task  he  may  well  check 
the  posting  of  the  receipt.  This  saves  the  turning  of 
pages  when  finally  the  checking  of  all  postings  is  to 
be  completed.  In  this  work  of  checking  receipts 
from  customers,  the  auditor  should  note  carefully 
whether  discounts  entered  on  the  cash  book,  as 
allowed  on  bills  collected,  agree  with  the  terms  of 
sale ;  for  it  is  comparatively  easy  for  a  cashier  having 
access  to  the  books  to  give  a  customer  credit  for  a 
discount  when  none  was  allowed  and  deflect  to  his 
own  pocket  the  extra  amount  of  cash  actually  paid 
by  the  customer  over  the  net  amount  of  the  bill. 
When  the  full  amount  of  bills  is  entered  on  one  side 
of  the  cash  book,  and  discount  on  the  other,  the  audi- 
tor should  note  whether  deposits  cover  the  fuU 
amount  reported  as  actually  paid.  If  he  finds  de- 
ductions from  bills  because  of  returned  sales,  he 
should  confirm  such  returns  by  the  receiving  book. 
He  should  also  verify  all  receipts  from  interest,  rents, 
mortgage  payments,  etc.,  and  see  that  Cash  was  deb- 
ited for  the  full  amount  called  for  by  the  debt.  He 
should  see  also  that  receipts  from  cash  sales,  as  en- 
tered on  the  cash  book,  agree  with  the  amount  shown 


426  ACCOUNTING  AND  AUDITING 

on  the  sales  book.  Wlien  notes  have  been  sold  and 
have  not  been  entered  on  the  cash  book,  the  bill  book 
should  disclose  their  existence.  If  such  notes  have 
been  omitted  from  that  book  also,  but  have  been  dis- 
counted with  the  bank  where  deposits  are  kept,  the 
proceeds  will  show  on  the  pass  book,  and  the  dis- 
crepancy in  the  reconciliation  will  disclose  the  issue. 
Otherwise  no  way  can  be  found  of  surely  detecting 
such  omissions  from  the  books.  When  any  notes 
have  been  discounted,  the  auditor  should  see  that  the 
net  amount  of  cash  reported  is  the  full  actual  pro- 
ceeds and  not  a  smaller  sum  which  leaves  a  margin 
for  embezzlement. 

The  auditor  should  examine  the  extension  of  all 
cash  items  into  special  columns  and  make  sure  that 
none  are  included  in  wrong  totals.  When  all  items 
on  the  cash  book  have  been  passed,  the  footings  of 
the  book  should  be  figured,  the  balance  determined, 
and  the  posting  checked  into  the  general  ledger  (or, 
if  cash  is  not  posted,  the  cash  item  on  the  trial  bal- 
ance checked). 

When  counting  cash  it  is  desirable  to  make  a 
memorandum  of  the  specific  items  counted — so  that 
none  may  be  presented  a  second  time.  This  list 
should  include  the  amount  of  each  denomination  of 
cash,  any  so-called  ^^cash  items"  (with  full  memoran- 
dum for  later  identification),  and  all  checks  awaiting 
deposit.  **Cash  items,"  which  are  mere  memoranda 
of  temporary  loan,  cash  in  transit,  etc.,  should  not  be 
passed  unless  they  have  been  vouched  by  some  person 
in  authority. 

The  auditor  naturally  proceeds  next  to  the  jour- 
nal.    Since  journal  items  are  likely  to  be  few  in 


AUDITING  437 

number  and  scattered  through  the  general  ledger,  a 
considerable  waste  of  labor  in  turning  pages  is  likely 
to  be  avoided  if  the  postings  are  checked  in  a  some- 
what peculiar  order.  It  is  usually  wise  after  the  first 
journal  entry  is  checked  in  the  ledger  to  note,  while 
the  ledger  is  open  at  that  account,  what  other  journal 
entries  are  posted  to  that  account,  and  then  check 
these  in  the  journal  before  checking  the  second  jour- 
nal entry.  The  method,  therefore,  is  to  check  the 
first  journal  entry  from  the  journal  to  the  ledger;  to 
check  all  other  postings  of  that  account  in  the  ledger 
back  into  the  journal;  to  check  the  second  journal 
posting  into  the  ledger;  to  check  back  into  the  jour- 
nal all  other  postings  from  the  journal  to  that  ledger 
account;  and  so  on  until  all  ledger  items  have  been 
checked.  The  finding  of  journal  entries  for  ledger 
accounts  is  usually  much  less  work  than  the  finding 
of  ledger  accounts  from  journal  entries;  for,  whereas 
the  ledger  may  cover  many  hundred  pages,  and 
checking  to  it  may  involve  much  turning  of  leaves, 
the  journal  is  likely  to  cover  a  comparatively  small 
number  and  so  items  can  be  easily  found.  In  audit- 
ing journal  items  the  same  precautions  should  be  fol- 
lowed as  in  auditing  items  appearing  on  the  cash 
book.  In  addition,  however,  certain  items  are  likely 
to  require  certification  by  officers  in  authority. 
Charges  to  Bad  Debts,  for  instance,  should  be  au- 
thorized; else,  as  we  have  seen,  they  may  be  substi- 
tuted for  Cash.  Many  journal  items  are  likely  to  be 
transfers  and  to  involve  adjustments.  For  these  no 
adequate  vouchers  can  usually  be  found;  and,  there- 
fore, it  is  wise  for  the  auditor  to  request  that  all  jour- 
nal entries  be  signed  by  the  person  having  the  proper 


428  ACCOUNTING  AND  AUDITING 

authority,  or  that  such  person  give  him  a  certificate 
that  the  signer  accepts  responsibility  for  the  correct- 
ness of  the  entry.  If  the  person  who  should  authorize 
the  entry  is  not  sure  that  it  is  correct,  he  should  ask 
the  auditor's  judgment  on  the  matter,  and  then  he 
may,  if  he  desires,  indicate  on  his  certificate  that  the 
entry  was  made  on  the  advice  of  the  auditor;  but  in 
any  case  the  auditor  should  demand  that  some  person 
in  authority  be  responsible  for  truthful  representa- 
tion of  the  circumstances  which  gave  rise  to  the 
entry.  The  auditor  will  do  well  to  make  a  copy  of  all 
items  relating  to  bonds,  stocks,  capital,  and  closing 
entries  for  the  determination  and  disposition  of 
profits;  for  as  these  are  matters  which  should  enter 
into  the  report  made  to  his  client,  he  may  well  have 
copies  in  his  working  papers  and  not  be  forced  to 
rely  on  the  original  books.  The  auditor  should  ob- 
serve'that  the  total  debits,  as  shown  by  the  journal, 
equal  the  total  credits.  If  there  are  special  columns 
in  the  journal,  he  should  go  over  all  the  footings;  and 
he  must  by  checking,  of  course,  see  that  all  items  are 
properly  posted. 

The  order  to  be  followed  in  auditing  the  other 
books  is  not  of  much  consequence.  We  may  well 
take  them  here  chronologically. 

The  first  is  the  order  book  to  indicate  what  orders 
have  been  issued  for  the  purchase  of  supplies  and 
merchandise.  If  this  book  is  properly  kept,  no  pur- 
chases are  authorized  unless  they  first  appear  here. 
The  auditor  will  use  it,  therefore,  for  confirming 
purchases. 

If  a  receiving  book  is  kept,  the  auditor  should 
compare  the  record  of  goods  received  with  the  pur- 


AUDITING  429 

chase  book  and  make  sure  that  all  receipts  have  been 
properly  debited  to  Supplies  or  Merchandise  and 
credited  to  the  shippers. 

The  purchase  book  should  be  examined  to  see 
whether  any  items  appear  there  which  have  not 
already  been  checked  as  confirmed  by  the  order  book 
and  the  receiving  book,  whether  items  have  been 
properly  distributed  to  various  departments  (if  pur- 
chases are  debited  to  more  than  one  account), 
whether  the  footings  have  been  properly  taken, 
whether  (if  there  are  several  purchase  accounts)  the 
cross-footing  of  totals  agrees  with  the  total  of  all 
purchases,  and  whether  postings  have  been  properly 
made  to  the  general  ledger.  It  is  not  always  neces- 
sary for  the  auditor  to  check  purchases  into  the  pur- 
chase ledger;  for  if  all  purchases  have  been  properly 
credited  to  Creditors,  and  the  balance  of  creditors' 
accounts  in  the  purchase  ledger  agrees  with  Credit- 
ors in  the  general  ledger,  it  is  presumable  that  these 
accounts  are  correct  in  detail.  The  chief  possibility 
of  error  is  that  some  item  will  get  upon  a  wrong  ac- 
count. This  may  be  provided  against  by  communi- 
cation with  creditors,  as  will  be  shown  later. 

If  a  separate  book  is  kept  for  returned  purchases, 
this  should  be  examined  very  much  as  the  purchase 
book  is  examined,  by  the  method  above  described. 
Such  returned  purchases  should  be  entered  in  a  ship- 
ments book.  This  will  furnish  the  confirmation  for 
the  debits  to  creditors'  accounts;  and  the  total  of 
such  returned  purchases  should  be,  of  course,  debited 
to  Creditors  in  the  general  ledger.  These  may  well 
be  checked  into  the  creditors'  ledger  as  a  protection 
against  overstatement  of  cash  payments — unless  this 


430  ACCOUNTING  AND  AUDITING 

has  already  been  provided  against  by  the  method 
suggested  for  auditing  cash  disbursements  (page 
424). 

A  thorough  examination  of  the  stock  book,  if  any 
such  is  kept,  is  likely  to  be  a  considerable  task,  but 
it  should  not  be  shirked  if  a  complete  audit  is  de- 
sired. It  is  impossible,  of  course,  for  the  auditor 
to  go  behind  the  inventory  for  the  beginning  of  the 
period  under  audit,  but  he  should  require  that  this 
inventory  be  presented  to  him  and  that  it  bear  the 
signature  of  someone  in  authority  who  accepts  it  as 
of  the  beginning  of  the  period.  If  the  receiving  book 
shows,  as  it  should,  all  receipts  since  that  inventory, 
and  the  shipping  book  shows  all  shipments  since 
that  inventory,  the  auditor  has  in  his  own  hands  the 
means  of  determining  the  present  inventory.  If,  on 
the  other  hand,  the  books  cannot  be  kept  on  this  care- 
ful plan — ^because,  for  instance,  goods  come  in  and 
out  without  passage  through  the  receiving  and  ship- 
ping rooms, — the  auditor  cannot  learn  the  gradual 
changes  in  the  stock  on  ,hand  and  must  fall  back  on 
an  inventory  at  the  end  of  the  period.  For  this, 
however,  he  should  demand  the  signature  of  some- 
one in  authority.  He  should  test  the  prices  by  recent 
invoices.  In  many  lines  of  business  in  which  it 
is  customary  to  fix  prices  at  a  certain  percentage  of 
cost,  one  can  from  the  sales  alone  approximate  the 
cost  of  the  goods  sold.  By  combining  the  inventory 
at  the  start,  the  purchases,  and  the  presumable  cost 
of  the  goods  sold,  one  can  get  the  present  inventory. 
This,  of  course,  can  be  nothing  more  than  an  ap- 
proximation ;  but  it  may  serve  as  a  check  on  radically 
erroneous  statements  of  present  stock. 


AUDITING        •  431 

Where  possible,  the  sales  book  should  be  com- 
pared with  the  shipping  book  so  as  to  show  whether 
all  the  goods  shipped  were  charged  to  customers. 
The  auditor  should  verify  the  extensions  of  price 
and  thus  make  sure  that  no  error  was  made  in  charg- 
ing a  customer  less  than  the  proper  amount;  he 
should  verify  the  footings  of  the  sales  book,  and 
should  check  the  postings  to  the  general  ledger — 
both  for  the  debit  to  Customers  and  for  the  credit  to 
Merchandise.  It  is  not  always  necessary  to  check 
the  postings  to  the  sales  ledger,  for  the  examination 
of  customers'  accounts,  to  be  considered  later,  may 
obviate  this. 

If  a  book  is  kept  for  goods  shipped  on  approval, 
this  should  be  examined  carefully  to  see  whether  it 
contains  all  items  marked  on  the  shipments  book  as 
for  this  purpose,  and  whether  all  items  show^n  by  it 
to  have  been  retained  have  been  properly  debited  on 
the  sales  book.  Goods  returned,  as  shown  by  this 
approvals  book,  should  be  traced  ii^to  the  receiving 
book.  If  any  items  of  long  standing  on  this  book 
have  been  neither  returned,  as  shown  by  the  receiv- 
ing book,  nor  debited  on  the  sales  book,  an  investiga- 
tion should  be  made.    All  such  items  should  be  listed. 

If  a  separate  book  is  kept  for  C.  O.  D.  items,  the 
amounts  should  be  traced  into  the  sales  book  to  see 
that  all  items  have  been  accounted  for. 

Let  us  now  turn  to  the  ledgers.  For  the  general 
ledger  it  is  necessary  to  go  over  all  postings  to  make 
sure  that  all  items  have  been  checked  as  agreeing 
with  some  book  of  original  entry.  If  any  remain 
imchecked,  they  should  be  listed  for  future  refer- 
ence.   Memorandum  should  be  made   of  any  ap- 


482  ACCOUNTING  AND  AUDITING 

parent  irregularities.  The  balance  of  each  account 
should  be  figured,  and  the  result  should  be  checked 
to  the  trial  balance. 

If  controlling  accounts  have  been  accurately  kept 
to  represent  dealings  with  creditors  and  customers, 
the  balance  of  each  particular  account  of  a  creditor 
or  a  customer  is  not  of  primary  importance  for  an 
auditor;  for  any  discrepancies  must  lie  in  an  over- 
statement of  one  account  offset  by  an  understate- 
ment of  another.  Since,  however,  there  is  oppor- 
tunity for  embezzlement  through  omission  of  receipts 
from  both  the  controlling  account  and  the  subordi- 
nate ledger  accounts,  it  is  the  auditor's  business  to 
get  confirmation  for  the  books  through  the  subordi- 
nate-ledger balances.  It  is  desirable  to  have  from 
all  persons  with  whom  the  business  has  relations  an 
occasional  confirmation  of  their  accounts.  It  is  well, 
therefore,  for  the  auditor  to  send  to  all  creditors  and 
to  all  customers  at  the  time  of  beginning  an  audit  a 
statement  showing  the  balance  on  their  accounts  as 
the  books  then  stand,  and  to  ask  for  a  return  of  the 
statement  endorsed  as  correct.  Though  usually  not 
all  such  statements  will  be  return^ed,  if  this  work  is 
done  at  annual  audits  each  account  is  likely  to  be 
confirmed  at  least  once  in  two  or  three  years,  and 
the  possibility  of  this  is  a  good  check  on  clerks  with 
dishonest  tendencies.  It  should  be  understood,  of 
course,  that  an  auditor  has  no  right  to  send  out  re- 
quests for  confirmation  without  the  consent  of  his 
client.  The  task  of  making  statements  for  confirma- 
tion is  not  so  great  as  might  at  first  sight  appear,  for 
the  regular  monthly  statements  may  be  utilized  for 
this  purpose.    If  the  auditor  accepts  the  statements 


AUDITING  433 

f 

prepared  by  the  bookkeeper,  compares  them  with  the 
books,  puts  upon  them  a  private  mark  which  cannot 
be  duplicated  by  the  bookkeepers,  and  then  requests 
that  this  particular  statement — and  not  another 
which  may  be  substituted  for  it — be  returned  to  the 
auditor's  own  address,  the  check  is  complete.  For 
the  auditor's  private  mark  he  may  provide  a  rubber 
stamp  with  some  characteristic  that  is  not  easily  ob- 
served by  the  uninitiated — such,  for  instance,  as 
slight  flaws  or  irregularities  (cut  in  the  letters) 
which  could  hardly  be  detected  by  anyone  not  in  the 
secret. 

If  this  test  by  calling  for  confirmation  is  not 
feasible  to  apply,  the  auditor  should  check  all  post- 
ings of  the  purchase  ledger  and  sales  ledger  from  the 
books  of  original  entry.  A  bookkeeper  knowing 
that  this  will  be  done  is  little  likely  to  substitute  a 
debit  to  a  customer  for  a  debit  to  cash. 

We  now  assume  that  the  books  have  been  care- 
fully examined  to  learn  that  all  expenditures 
have  been  properly  vouched  for,  that  all  receipts 
have  been  properly  credited,  that  all  postings  have 
been  made  to  the  ledger,  and  that  all  balances  have 
been  properly  figured.  If  during  the  process  of  the 
audit  all  items  have  been  checked  when  verified,  ex- 
amined, or  posted,  no  item  should  remain  either  in  a 
book  of  original  entry  or  in  the  ledger  without  the 
auditor's  private  check  mark  or  a  memorandum  call- 
ing attention  to  its  irregularity.  When  this  work  is 
supposed  to  be  complete,  all  the  books  should  be  ex- 
amined finally  for  assurance  that  each  item  does  actu- 
ally bear  its  proper  check  marks.  Several  kinds  of 
check  marks  should  be  used,  for  otherwise  a  check 

A  &  A-28 


434  ACCOUNTING  AND  AUDITING 

given  for  one  purpose  may  be  interpreted  as  for  an- 
other. Cash  book  items,  for  instance,  are  likely  to 
need  three  kinds  of  marks — one  for  bank  verification, 
one  for  vouching,  and  one  for  posting. 

If  the  auditor  finds  in  the  coin-se  of  his  work  that 
some  errors  of  accounting  have  been  made,  he  should 
merely  make  memoranda  of  the  necessary  adjust- 
ments and  postpone  the  correcting  entries  until  his 
examination  is  complete;  for  he  may  later  find  coun- 
tervailing facts  which  alter  his  first  conclusions. 
Mere  bookkeeping  errors  he  should  correct  as  he  goes 
along,  however, — ^though  not  without  authority. 

If  when  the  examination  of  the  books  is  supposed 
to  be  complete  a  new  trial  balance  is  taken  directly 
from  the  books  and  the  totals  of  all  books  posted  in 
lump  sum  are  copied  into  the  working  papers,  the 
present  figures  should  agree  with  the  figures  origi- 
nally taken  off  at  the  beginning  of  the  audit  (allow- 
ing for  the  adjustments  made  during  the  course  of 
the  audit  or  at  its  close).  If  a  discrepancy  persists 
between  the  original  figures  and  the  final  working 
figures  (after  allowing  for  the  adjustments),  ob- 
viously someone  has  been  tampering  with  the  books 
during  the  course  of  the  audit,  and  the  figures  which 
show  a  discrepancy  should  be  examined  so  that  the 
auditor  may  learn  who  has  been  making  unauthor- 
ized changes. 

We  are  now  supposing  the  audit  to  have  pro- 
gressed so  far  as  to  vouch  for  the  correctness  of  the 
bookkeeping.  The  auditor's  next  task  is  to  pass 
judgment  upon  matters  of  accounting  which  have 
not  already  arisen  in  connection  with  the  examina- 
tion of  the  bookkeeping.    Let  us  take  first  the  con- 


AUDITING  ^  435 

siderations  involved  in  passing  upon  a  balance  sheet. 
We  may  as  well  take  these  in  alphabetical  order. 

The  auditor  should  see  that  accounts  payable  re- 
ported are  for  legitimate  debts,  and  that  no  invoices 
which  have  been  once  paid  are  included;  invoices 
should  bear  dates  that  are  properly  related  to  the 
present  time. 

He  should  see  that  accounts  receivable  reported 
are  in  conformity  with  the  original  charges,  and  that 
included  among  them  are  not  debts  so  long  overdue 
that  presumably  no  collection  can  be  made  on  them. 
Allowance  must  be  made  for  discounts  offered  and 
for  probable  bad  debts. 

If  bonds  are  outstanding  and  any  trustee  has  been 
appointed  as  a  registrar,  the  auditor  should  secure 
from  the  trustee  a  certificate  to  the  effect  that  only 
as  many  bonds  are  outstanding  as  are  reported  on 
the  balance  sheet.  If  any  bonds  owned  are  reported 
as  deposited  for  collateral,  the  auditor  should  pro- 
cure from  the  holders  a  certificate  showing  just  what 
is  so  held. 

The  auditor  should  make  sure  that  all  bills  receiv- 
able presented  to  him  as  good  assets  are  genuine,  and 
that  the}^  are  presumably  good.  In  order  to  make 
his  work  complete  he  should  seek  from  the  makers 
and  endorsers  of  such  notes  confirmation  as  to  their 
amount  and  genuineness.  Unsecured  notes  long 
overdue  should  not  be  considered  as  good  assets,  but 
should  be  charged  back  to  those  from  whom  the 
business  took  them — and  possibly  the  resulting  book 
accounts  should  be  closed  out  to  Bad  Debts.  If  any 
notes  have  been  discounted  or  turned  over  to  banks 
for  collection,  and  are ,  therefore  not  in  the  posses- 


436  ACCOUNTING  AND  AUDITING 

sion  of  the  business,  the  auditor  should  get  from  the 
banks  holding  such  notes  certification  of  their 
amount,  makers,  and  dates. 

Since  the  auditor  cannot  ordinarily  know  how 
good  are  the  book  debts  and  the  notes  of  any  busi- 
ness, he  ma}^  well  demand  from  someone  in  authority 
a  written  statement  as  to  their  probable  value.  If 
any  reserve  has  been  set  aside  for  doubtful  debts,  he 
may  base  on  that  statement  his  judgment  concerning 
the  adequacy  of  that  reserve. 

If  any  trust  company  or  other  outside  agency  is 
registrar  for  capital  stock  issued,  the  auditor  should 
require  from  such  agent  a  certificate  as  to  the  amount 
of  stock  outstanding,  and  should  see  that  it  is  re- 
ported on  the  balance  sheet  at  that  figure. 

If  any  claims  are  reported  among  the  assets,  he 
should  see  that  allow^ance  has  been  made  for  any 
which  are  disputed,  and  that  only  those  presumably 
collectible  are  counted. 

If  any  securities  are  shown  to  him  as  collateral 
for  debts  held  by  the  business,  the  auditor  should  by 
communication  with  the  owners  of  the  securities 
learn  whether  they  are  correctly  reported  as  pledged 
for  the  debt  concerned. 

If  the  business  maintains  branches,  the  auditor 
must  watch  caref uUj^  to  see  that  the  accounts  are  not 
so  mixed  as  to  count  assets  twice  and  liabilities  not  at 
aU.  If,  for  instance,  the  branch  buys  goods  of  the 
main  house  and  gives  its  notes  in  payment,  fraudu- 
lent accounting  might  report  the  merchandise  as  an 
asset  for  each  house,  the  Bills  Receivable  as  an  asset 
of  the  main  house,  but  .the  Bills  Payable  not  at  all. 
For  each  of  these,  good  ground  can  be  found ;  but  no 


AUDITING  437 

ground  can  be  found  for  all  of  tliem  at  once.  The 
merchandise  is  an  asset  for  either  house,  but  not  for 
both;  the  Bills  Receivable  is  an  asset  for  the  main 
house,  but  then  the  Bills  Payable  is  a  liability  of  the 
branch ;  the  Bills  Payable  may  be  neglected  as  a  lia- 
bility, for  it  is  purely  internal,  but  then  the  Bills 
Receivable  must  not  be  counted  as  an  asset.  In  other 
words,  the  two  sets  of  books  must  be  absolutely  dis- 
tinct or  absolutely  consolidated. 

The  auditor  should  examine  the  minutes  of  a  cor- 
poration to  learn  whether  any  liabilities  incurred 
have  been  omitted  from  the  balance  sheet.  If  the 
corporation  is  new,  moreover,  he  should  inspect  all 
prospectuses  and  other  promises  made  to  persons  in- 
vited to  subscribe  to  stock,  and  should  observe 
whether  any  promises  have  failed  of  fulfillment. 

The  auditor  should  make  sure  that  all  dividends 
declared  and  matured  have  been  paid,  or  that  the 
amount  unpaid  remains  as  a  liability  shown  on  the 
balance  sheet.  If,  as  is  commonly  done,  a  corpora- 
tion makes  a  special  bank  deposit  to  cover  the  pay- 
ment of  dividends,  the  unexpended  balance  of  that 
account  represents  the  unpaid  dividends;  and,  there- 
fore, the  dividends  do  not  need  to  appear  as  liabili- 
ties if  that  bank  balance  is  not  included  among  the 
assets;  but  if  the  bank  balance  is  so  included  in  cash, 
the  dividends  must  appear  as  a  liability.  The  same 
thing  is  true  for  unpaid  interest  on  bonds  outstand- 
ing. For  coupon  bonds,  the  unredeemed  matured 
coupons  measure  the  liability. 

The  auditor  should  demand  of  a  person  in  au- 
thority a  certificate  that  the  assets  shown  on  the 
books  as  plant,  machinery,  and  other  things  not  sus- 


458  ACCOUNTING  AND  AUDITING 

ceptible  of  adequate  valuations  at  sight  by  tlie  audi- 
tor, are  actually  in  possession  of  the  company  and 
unimpaired — or  that  the  amount  of  depreciation 
allowed,  either  in  a  fund  or  as  a  liability,  is  adequate 
to  cover  shrinkage. 

He  will  do  well  to  learn  from  the  records  of  deeds 
whether  any  mortgages  have  been  issued. 

In  case  a  corporation  has  issued  income  bonds  of 
a  cumulative  sort  (that  is,  bonds  which,  though  they 
3deld  interest  only  if  the  interest  is  earned  in  the 
years  covered,  yet  demand  the  payment  of  interest  in 
later  years  to  offset  the  failure  of  interest  in  the  lean 
years)  or  cumulative  preferred  stock  (which  requires 
that  dividends  not  paid  in  one  year  shall  be  made  up 
out  of  later  earnings  before  common  stock  shall  pay 
dividends),  the  report  of  the  corporation  should 
show  any  such  arrears.  These  arrears  are  not  direct 
liabilities,  however,  for  they  are  not  claims  against 
the  company  until  earnings  have  been  made;  in  other 
words,  they  are  not  claims  against  the  company  in 
any  way  to  affect  its  solvency;  and  since  the  purpose 
of  a  balance  sheet  is  primarily  to  show  solvency,  they 
do  not  need  to  appear  among  the  liabilities.  They 
may  well  be  given  in  a  footnote  or  in  an  appended 
statement,  however,  for  they  do  affect  the  investment 
value  of  the  stocks  and  bonds. 

The  auditor  should  examine  the  income  sheet  and 
see  that  the  charges  bear  correct  relation  to  the  parts 
of  the  business  which  cause  them.  Depreciation 
charged  on  the  income  sheet  should  agree  in  amount 
with  the  depreciation  deducted  from  assets.  Inter- 
est on  the  income  sheet  should  bear  the  correct  rela- 
tion to  investments  and  to  interest-bearing  debts 


AUDITING  439 

outstanding.  Allowance  for  bad  debts  deducted  from 
gross  earnings  should  agree  with  the  changes  shown 
on  the  balance  sheet.  Accrued  items  on  the  balance 
sheet  should  be  included  in  the  totals  of  income-sheet 
earnings  and  expenses.  The  income  sheet  final  bal- 
ances should  be  included  in  balance-sheet  balances. 
The  income  sheet  and  the  balance  sheet  must  be  con- 
sistent, for  they  are  different  statements  for  the  same 
final  result — as  we  saw  on  a  sixycolumn  statement. 

Let  us  now  turn  to  the  auditor's  report.  He 
should  state  in  the  first  place  what  work  he  has  actu- 
ally done,  that  is,  what  sort  of  audit  he  has  con- 
ducted, and  if  he  has  been  requested  by  anyone  in 
authority  to  omit  any  work  ordinarily  done,  or  has 
been  excused  from  such  work,  he  should  note  in  his 
report  that  omission.  He  should  never  in  his  conclu- 
sions state  what  are  to  him  mere  opinions.  His  task 
is  to  learn  the  facts  about  the  books  and  about  the 
business,  and  to  state  whether  the  books  show  the 
facts  as  they  appear  to  him  to  be.  He  may  state  his 
opinion  with  regard  to  allowances  for  depreciation, 
bad  debts,  etc.,  but  those  are  opinions  only  in  the 
sense  that  they  are  matters  of  judgment;  but  he 
should  not  state  an  opinion  as  to  the  management  of 
the  business  or  the  honesty  of  those  conducting  it 
until  that  opinion  has  become  practically  a  certainty 
based  upon  proof  which  he  can  present.  If  he  re- 
ports all  material  facts,  including  a  statement  of  all 
irregularities,  as  has  been  suggested,  his  clients  are 
likely  to  be  in  a  better  position  than  he  to  form  mere 
opinions.  Clients  usually  welcome  suggestions  for 
improved  methods,  however.     In  other  words,  the 


440  ACCOUNTING  AND  AUDITING 

auditor's  work  should  be  constructive  rather  than 
destructive. 

The  auditor's  report  is  supposed,  usually,  to  show 
the  condition  of  the  business  both  at  the  beginning 
and  at  the  end  of  the  period  under  examination.  He 
should  therefore  show  a  balance  gheet  for  the  two 
periods,  or  a  combined  balance  sheet  showing  the  fig- 
ures for  the  beginning  and  the  end,  with  the  increases 
or  decreases.  He  should  show  also  a  summary  of 
important  balance-sheet  changes  arranged  somewhat 
after  the  fashion  of  the  table  given  on  page  341. 
He  should  show  not  only  the  income  sheet,  but  a  clear 
statement  of  the  disposition  of  the  income — to  divi- 
dends, surplus,  and  other  reserves.  Matters  which 
are  largely  determined  by  judgment  should  be  pre- 
sented in  the  report  in  such  form  that  others  having 
slightly  different  bases  of  judgment  may  be  enabled 
to  draw  their  own  conclusions.  The  auditor  should 
therefore  append  to  his  report  a  list  of  bad  debts 
charged  off,  of  bills  receivable,  of  accounts  receiv- 
able, and  a  statement  of  the  amount  of  inventory  and 
the  basis  on  which  it  was  verified.  He  should  add  a 
statement  of  bills  payable  and,  if  it  is  likely  to  prove 
of  any  value  to  readers  of  the  report,  of  the  accounts 
payable.  He  may  well  add  a  list  of  securities  owned, 
of  delinquent  debtors,  and,  if  his  audit  is  primarily 
for  the  purpose  of  detecting  dishonesty,  a  list  of  out- 
standing checks.  He  should  in  all  cases  append  a 
list  of  missing  checks  and  of  missing  vouchers. 

Let  us  turn  now  to  the  matter  of  examinations 
for  creditors  or  possible  investors.  If  a  client  who 
requests  an  examination  is  willing  to  pay  for  a  com- 
plete audit,  and  the  persons  whose  business  is  under 


.AUDITIN'G  441 

examination  do  not  object,  this  is  usually  desirable. 
If,  however,  this  is  not  feasible,  much  work  neces- 
sary for  a  complete  audit  may  be  omitted  in  this  ex- 
amination. The  purpose  of  an  examination  is  to 
learn  whether  the  assets  are  real  and  whether  the 
profits  are  as  represented.  The  examination  need 
ordinarily  go  no  farther  than  to  ascertain  these  facts. 
The  auditor  is  not  expected  to  vouch  for  the  honesty 
of  employees  or  officers. 

The  auditor  will  naturally  begin  by  making  a 
copy  of  the  trial  balance  for  the  beginning  and  for 
the  end  of  the  period  under  examination.  A  com- 
parison of  these  will  furnish  a  summary  of  the  busi- 
ness. It  may  be  worth  while  to  make  a  complete  copy 
of  each  property  account,  for  then  he  will  know  what 
expenditures  have  been  made  on  its  behalf,  and  what 
receipts  have  accrued  from  it.  The  next  step  is  for 
the  auditor  to  make  sure  that  the  trial  balance  faith- 
fully represents  the  ledger.  He  should  go  through 
the  ledger  carefully,  take  footings  and  balances,  and 
see  that  the  trial  balance  figures  correspond. 

The  next  task  is  for  the  auditor  to  examine  the 
reality  of  the  assets,  and  this  should  be  done  in  the 
main  as  it  is  done  for  a  complete  audit.  He  should 
note,  moreover,  that  the  future  has  not  been  antici- 
pated— for  instance,  by  the  premature  cutting  of 
coupons  on  bonds.  Some  assets,  however,  do  not 
need  in  this  case  examination  quite  so  cai'eful  as  is 
required  where  the  piu*pose  of  the  audit  is  to  learn 
whether  fraud  has  been  committed  by  employees.  If 
the  proprietor  is  willing  to  certify  to  a  list  of  ac- 
counts receivable  as  legitimate  debts  due  to  the  busi- 
ness, it  is  hardly  necessary  for  the  auditor  to  conduct 


442  ACCOUNTING  AND  AUDITING 

an  audit  of  the  customers'  ledger — unless,  indeed,  he 
thinks  that  the  proprietor  may  be  committing  an 
innocent  error  due  to  the  fraud  of  his  own  employees. 
In  that  case,  the  auditor  will  do  well  to  investigate 
the  accounts  as  suggested  for  a  complete  audit.  It 
must  be  understood,  however,  that  a  man  certifying 
to  assets  of  his  business,  though  he  is  liable  both 
civilly  and  criminally  for  any  intentional  fraud,  is 
not  liable  for  errors  due  to  lack  of  judgment.  The 
auditor  must  therefore  use  such  means  as  he  has  at 
his  disposal  for  learning  how  much  the  book  accounts 
are  actually  worth  for  collection  purposes.  He 
should  go  through  them  and  report  how  many  are 
overdue,  how  many  are  collectible  from  customers 
who  in  the  past  have  proved  not  thoroughly  reliable, 
and  how  many  ought  to  be  written  off  as  bad  debts. 

The  auditor  should  make  a  list  of  all  assets  after 
he  has  examined  them  as  indicated  for  a  complete 
audit,  and  should  furnish  a  copy  of  that  list  to  his 
cUent;  for  if  the  client  is  going  to  purchase  an  in- 
terest in  the  business,  he  should  have  in  his  posses- 
sion information  showing  exactly  what  he  has  pur- 
chased. If  this  is  not  done,  the  auditor  has  not  fore- 
stalled the  possibility  of  a  substitution  of  assets 
which  (though  it  may  be  innocent  and  the  proprietor 
may  consider  the  assets  substituted  quite  as  good  as 
those  originally  examined)  may  cause  heavy  loss  to 
the  client.  This  list  should  include  security  or  col- 
lateral for  all  debts  due  to  the  business,  insurance 
premiums  prepaid,  accrued  interest  and  declared 
dividends,  and  certified  inventories  of  merchandise. 

The  auditor  should  make  a  detailed  list  of  Liabili- 
ties; for  otherwise  liabilities  may  be  foisted  upon  the 


AUDITING  443 

purchaser.  These  liabilities  should  be  learned  by 
the  methods  previously  indicated. 

The  auditor  should  read  through  the  cash  book 
and  the  journal,  even  when  he  does  not  need  to  vouch 
them  or  check  them  with  the  ledger;  for  they  may 
throw  valuable  light  on  the  valuation  of  assets,  the 
sources  of  profit,  the  causes  of  loss,  and  the  methods 
previously  in  vogue  for  determining  profit  and  loss. 
He  should  make  note  of  all  entries  which  cast  doubt 
on  the  correctness  of  trial-balance  figures. 

He  should  be  on  the  watch  for  the  ^^ salting"  of 
assets  and  sales.  He  should  realize  that  the  purpose 
of  the  seller  of  a  business,  however  honest  he  may  be 
in  intent,  is  to  get  as  much  for  his  business  as  he 
thinks  it  is  worth  and  that  an  optimistic  tempera- 
ment is  likely  to  see  more  value  and  profit  than  does 
a  skeptical  purchaser.  The  auditor  must  make  sure, 
then,  that  the  sales  reported  are  actually  sales.  He 
should  add  the  columns  of  the  sales  books  and  see 
that  the  proper  amounts  have  gone  to  the  ledger. 
He  should  add  the  columns  of  the  purchase  books 
and  see  that  those  are  properly  posted.  He  should 
do  the  same  for  returned  sales  and  returned  pur- 
chases. He  may  then  wisely  make  tables  showing 
the  monthly  totals  of  sales,  purchases,  returned  sales, 
and  returned  purchases,  for  recent  years,  and  thus 
learn  whether  any  suspicious  fluctuations  have  oc- 
curred,— Shaving  regard,  of  course,  to  the  di:fferent 
activity  of  di]fferent  seasons.  A  sudden  and  recent 
increase  of  sales  suggests  sales  to  persons  of  doubt- 
ful credit,  or  even  fictitious  sales — that  is,  sales  to 
confederates  v>  ith  an  understanding  that  goods  may 
be  returned  later.    A  sudden  and  recent  decline  in 


444  ACCOUNTING  AND  AUDITING 

purchases  suggests  an  exhaustion  of  stock  or  a  post- 
ponement of  entry  for  debts  actually  incurred.  Spe- 
cial care  should  be  taken  to  see  that  all  goods  inven- 
toried have  been  entered  as  purchases.  Sudden  and 
recent  increases  in  cash  balances  deserve  investiga- 
tion— ^lest  they  have  arisen  from  liabilities  not 
recorded. 

The  auditor  should  note  any  outside  relations 
that  the  business  has  with  members  of  the  firm,  with 
directors,  and  with  their  relatives  and  friends;  for 
sometimes  such  relations  are  unprofitable,  and  some- 
times, if  profitable,  they  may  cease  when  the  business 
changes  ownership. 

Sometimes  certain  statistical  information  is  of 
great  value  to  a  client  in  enabling  him  to  judge 
whether  a  business  is  doing  what  it  should.  A  table 
showing  for  a  series  of  years  the  percentage  of  sales 
to  capital  (commonly  called  the  ^* turnover"),  of  ex- 
penses to  sales,  of  working  capital  to  sales,  of  losses 
by  bad  debts  to  sales,  will  give  an  indication  not  only 
of  the  absolute  standing  of  the  business,  but  of  its 
tendency. 

The  auditor  should  note  whether  all  expenses 
have  been  actually  charged — ^not  only  depreciation, 
but  proprietors'  salaries  and  interest  on  proprietors' 
capital. 

The  work  of  an  auditor,  in  other  words,  comprises 
the  practical  application  of  all  the  principles  which 
have  been  discussed  in  various  connections  in  this 
book.  An  auditor  must  see  not  only  that  the  book- 
keeping is  correct,  but  that  sound  accounting  prin- 
ciples are  applied  in  all  matters  of  judgment.  No 
attempt  has  been  made  in  this  chapter  to  repeat  the 


AUDITING  445 

principles  of  the  preceding  chapters.  It  is  to  be  un- 
derstood that  wherever  a  principle  is  enunciated  as 
covering  original  entries,  it  is  equally  applicable  to 
the  interpretation  of  those  entries,  and  to  an  audi- 
tor's acceptance  or  rejection  of  them. 

Many  problems  arising  in  an  auditor's  work  are 
peculiar  to  the  kind  of  business  or  the  particular  cir- 
cumstances on  which  he  happens  to  be  at  any  time 
engaged.  It  is  impossible  in  a  book  of  this  sort  to 
cover  all  kinds  of  businesses  and  all  circumstances. 
Problems  are  arising  in  auditing  railroad  accounts, 
for  instance,  gas  company  accounts,  mining  ac- 
counts, accounts  of  charitable  institutions,  which  are 
unlike  any  here  indicated;  but  except  for  the  peculi- 
arities of  the  transactions  themselves  or  the  forms 
of  books  in  use,  they  will  not  be  found  to  require  the 
application  of  principles  different  from  those  given 
here.  No  man  can  expect  to  audit  satisfactorily  the 
books  of  any  business  unless  he  knows  the  nature  of 
the  work  performed  in  the  usual  course  of  that  busi- 
ness. The  first  step  of  an  auditor  should  always  be 
to  familiarize  himself  with  the  business  itself  and 
with  the  books  customarily  used. 

It  must  be  realized  by  every  bookkeeper,  account- 
ant, and  auditor,  that  he  stands  in  a  relation  to  his 
client  such  that  the  information  which  comes  to  him 
through  the  books  does  not  belong  to  him.  He  has 
no  more  right  to  use  it  for  his  own  benefit,  for  the 
benefit  of  his  friends,  or  even  to  tell  it  to  another  as 
a  mere  matter  of  interest,  than  he  has  to  use  for  his 
own  benefit  or  give  or  lend  to  another  the  merchan- 
dise, the  cash,  or  the  other  property  of  his  client.  It 
is  not  enough  for  him  to  realize  merely  that  he  must 


446  ACCOUNTING  AND  AUDITING 

not  make  use  of  his  information  or  turn  it  over  to 
friends  who  may  make  use  of  it:  he  must  realize  that 
after  information  has  once  passed  his  lips  he  has  no 
knowledge  as  to  what  may  become  of  it.  Though  he 
tells  business  secrets  only  to  acquaintances  who  he 
knows  have  absolutely  no  use  for  that  information, 
he  cannot  know  that  those  friends  will  not  allow  it 
also  to  escape  them  and  become  the  property  of  an- 
other who  may  use  less  discretion  in  its  spread.  In- 
formation merely  interesting  sometimes  spreads 
until  it  reaches  someone  who  finds  it  profitable,  or 
until  its  spread  is  harmful  for  the  person  originally 
concerned — especially  if  it  be  perverted  in  the  spread. 
The  only  rule  for  a  person  concerned  in  the  accounts 
of  another  is  to  say  absolutely  nothing  about  the 
information  which  he  receives — even  to  members  of 
his  own  immediate  family.  '    ^ 

If  a  bookkeeper,  accountant,  or  auditor,  learns 
from  accounts  that  something  is  going  on  which  has 
his  hearty  disapproval,  so  hearty  that  he  cannot  con- 
scientiously have  part  in  it  even  to  the  extent  of 
being  a  silent  witness,  he  must  at  once  sever  his  con- 
nection with  the  firm  concerned.  Even  then,  how- 
ever, he  has  no  business  to  go  out  and  tell  his  dis- 
covery unless  he  is  sure  that  the  facts  which  have 
come  to  his  knowledge  show  criminality  and  require 
him  to  make  disclosures  to  the  officers  of  justice — 
disclosures  which  he  is  ready  to  repeat  in  open  court 
and  are  conclusive  evidence  of  legal  offense, — and 
these  disclosures  should  be  made  only  to  the  oflScers 
of  justice.  A  statement  of  suspicion  is  one  of  the 
most  harmful  statements  that  can  possibly  be  made. 
He  must  say  absolutely  nothing  or  else  come  boldly 


AUDITING  44? 

forward  and  help  the  authorities  to  punish  the  guilty; 
but  he  must  be  sure  of  his  ground  before  he  makes 
any  attempt  to  bring  to  justice  those  whom  he  con- 
siders  to  be  guilty.  Indeed,  it  is  the  duty  of  an  ac- 
countant, before  going  to  any  prosecuting  offi- 
cer, to  state  to  his  superiors  what  are  his  conclusions 
from  the  facts  and  give  them  opportunity  to  explain 
any  possible  misunderstandings.  If,  then,  he  is  sure 
that  legal  or  moral  wrong  has  been  committed, 
he  should  at  once  sever  his  connection  with  the 
firm.  Whether  he  shall  make  disclosures  is  a  mat- 
ter for  his  private  conscience.  He  must  avoid,  more- 
over, the  possibility  of  being  misunderstood, — must 
avoid  not  only  blackmail,  but  the  appearance  of 
blackmail.  He  must  not  allow  even  the  thought  that 
he  can  be  bought  off.  In  no  case  should  he  give  any 
slightest  hint  of  criminality  unless  he  has  made  up 
his  mind  that  if  his  employers  fail  to  explain  things 
satisfactorily  he  will  leave  them.  Then  he  must 
leave.  To  suggest  susi)icion  to  employers  and  then 
to  keep  still  because  of  fear  of  losing  his  position,  or 
because  his  salary  is  raised,  or  because  his  position 
is  made  more  attractive,  is  the  height  of  dishonor. 
In  other  words,  no  half-way  is  to  be  considered  for  a 
moment.  The  relations  between  employer  and  ac- 
countant are  so  confidential,  moreover,  that  the  com- 
munity and  even  the  courts  look  somewhat  askance 
at  anyone  who  violates  such  confidence.  The  in- 
former should  be  sure  before  taking  any  steps  toward 
prosecution  that  the  community's  need  for  his  infor- 
mation more  than  offsets  the  other  requirement  of 
loyalty  to  private  obligation. 

It  is  obvious  from  what  has  been  said  that  the 


448  ACCOUNTING  AND  AUDITING 

work  of  an  accountant  and  auditor  is  not  only  mathe- 
matical but  moral.  Throughout  his  work  he  must 
realize  that  he  is  drawing  lines  of  division,  and  that 
what  lies  on  one  side  of  a  line  may  belong  to  one  per- 
son while  that  lying  on  the  other  side  belongs  to 
another.  Unless  he  has  a  judicial  temper,  the  in- 
fluence of  those  with  whom  he  comes  in  contact  is 
likely  to  overtop  his  sense  of  responsibility  to  those 
who  are  distant;  and  this  he  must  not  allow.  Unless 
he  has  a  philosophical  mind,  he  will  be  unable  to 
make  important  distinctions  between  things  which 
on  their  faces  are  similar.  Unless  he  has  mathe- 
matical ability,  he  will  be  unable  to  perform  necessary 
calculations.  His  integrity,  moreover,  must  be  abso- 
lute. It  is  for  these  reasons  that  accounting  is  com- 
ing to  be  recognized  as  a  profession.  The  account- 
ant's relation  to  his  client  is  exactly  the  same  as  that 
of  the  physician  and  the  lawyer.  The  accountant 
is  taken  into  the  client's  confidence,  and  it  must  be 
known  that  he  will  keep  his  information  to  himself; 
he  must  have  education  and  abilitv,  or  he  will  not 
be  able  to  pass  judgment  in  difficult  problems;  he 
must  have  the  keen  moral  sense  to  realize  that  the 
purpose  of  accounting  is  to  tell  the  truth,  and  that 
the  truth  is  no  respecter  of  persons,  of  interests,  or 
of  consequences.  Of  late  years  a  strong  movement 
has  developed  for  the  control  of  corporations,  and 
the  means  of  control  most  commonly  recommended 
is  such  publicity  that  the  community  can  know  for 
each  corporation  whether  it  is  good  or  evil.  Such 
publicity  requires  the  services  of  a  large  army  not 
only  of  skilled  accountants,  but  of  accountants  of 
integrity;  and  therefore  the  promise  for  the  growth 


AUDITING  449 

of  this  profession  is  large.  Anyone  contemplating 
entrance  into  it,  on  the  other  hand,  must  realize  not 
only  the  mental  and  moral  attainment  essential  for 
it,  but  the  great  responsibility  involved  in  the  work. 


A  &  A-29 


APPENDIX 


TEST  QUESTIONS 

[These  questions  are  not  intended  to  cover  all  the  ground  of  th©  text, 
nor  are  all  the  questions  answered  directly  in  the  text.  The  purpose  of 
these  questions  is  to  enable  the  student  to  see  whether  he  has  done  his 
studying  with  sufficient  thoughtful  care,  and  to  suggest  to  him  the  sort  of 
problems  he  should  make  up  for  himself.  A  few  questions  given  here  can 
be  answered  by  reference  to  the  proper  paragraphs  in  the  chapters  to 
which  they  apply;  but  most  of  them  require  a  putting- together  of  separate 
ideas  expressed  in  the  text — involving  a  comparison,  or  a  correlation,  or  a 
new  application.] 

Chapter  I.    Introduction.    (Pages  13-17.) 

1.  What  is  the  difference  between  bookkeeping 
and  accounting? 

2.  Can  rules  of  thumb  be  given  for  the  solution 
of  accounting  problems  ? 

3.  Are  accounting  principles  to  be  used  before 
the  bookkeeping  entries  are  made,  after  such  entries, 
or  both  before  and  after  ? 

4.  What  are  the  three  fundamental  principles 
of  bookkeeping  ? 

Chapter  II.    Debit  and  Ceedit.     (Pages  19-32.) 

1.  Shall  we  debit  or  credit  John  Doe  when  he 
gives  us  his  note  for  the  payment  of  a  debt  due  us  ? 

453 


46«  ACCOUNTING  AND  AUDITING 

2.  Shall  we  debit  or  credit  Cash  when  we  pay 
for  merchandise? 

3.  Shall  we  debit  or  credit  Rent  for  sums  paid 
to  the  business  by  tenants  of  property  that  it  owns  ? 

4.  What  is  the  function  of  property  accounts  in 
bookkeeping? 

5.  What  is  the  function  of  nominal  accounts  in 
bookkeeping?    , 

6.  Why,  in  any  system  of  logical  bookkeeping, 
must  there  be  a  debit  for  every  credit  ? 


Chapter  III.    The  Method  of  Entry. 
(Pages  33-48.) 

1.  What  is  the  function  of  a  ledger  ? 

2.  How  do  items  get  into  a  ledger  ? 

3.  Are  any  books  absolutely  necessary  besides  a 
journal  and  a  ledger? 

4.  Is  the  modern  journal  usually  voluminous  ? 

5.  What  relation  does  the  cash  book  bear  to  the 
journal? 

6.  Does  double-entry  bookkeeping  require  at 
least  two  postings  for  each  transaction? 

7.  How  far  is  the  form  of  the  double-entry  cash 
book  different  from  that  of  the  parallel-column 
journal? 

8.  Why  may  not  items  go  directly  to  the  ledger 
without  previous  entry  in  another  book? 

9.  If  an  entry  has  been  made  debiting  Roe 
instead  of  Doe,  how  may  it  be  corrected  without 
erasure  ? 


QUESTIONS  4S3 

Chaptek  IV.    The  Common  Ledger  Accounts. 
(Pages  49-107.) 

1.  Show,  in  the  form  of  a  simple  journalization, 
what  should  be  debited  and  what  credited  in  each  of 
the  following  cases : 

Payment,  by  you,  of  wages  in  the  form  of  mer- 
chandise. 

Receipt,  by  you,  of  a  bond  which  you  have  agreed 
to  take  in  payment  of  an  accepted  draft. 

Writing  off  a  bad  debt  owed  you  by  a  customer. 

Interest  allowed  you  on  your  bank  deposit. 

A  discovery  that  in  an  invoice  of  goods  pur- 
chased to  be  sold  as  merchandise,  and  charged  as  mer- 
chandise, is  included  $100  worth  of  office  supplies,  and 
$100  worth  of  goods  shipped  to  the  proprietor's  resi- 
dence, and  broken  goods  to  the  value  of  $100. 

Receipt  of  a  promissory  note  for  an  account 
already  written  off  as  uncollectible. 

2.  What  should  be  debited  and  what  credited 
after  each  of  the  following  transactions? 

(a)  Buying  on  credit,  at  the  first  of  the  year, 
stationery  expected  to  last  eight  months. 

(6)     Paying  for  that  stationery  by  issuing  a  note, 
(e)     Paying  that  note. 

(d)  Exchanging  that  stationery  at  cost  (none 
being  used)  for  merchandise. 

(e)  Selling  that  merchandise  at  cost  and  receiv- 
ing a  note  in  payment. 

(f)  Collecting  cash  for  the  note. 

Now  what  is  the  net  result,  upon  ledger  balances, 
of  all  these  transactions? 


454  ACCOUNTING  AND  AUDITING 

3.    What  transactions  are  most  likely  to  have 
given  rise  to  the  following  journalizations:  ' 


Interest 

$50 

To  Cash 

$50 

Adam  Bede 

1000 

laterest 

50 

To  Bills  Payable 

1050 

Loss  and  Gain 

450 

To  Charles  Darnaj 

450 

4.  (a)  Jan.  1,  X  invests  in  a  partnership  a  note 
of  his  wife,  for  $5,000,  due  in  one  month.  (6)  Jan.  14, 
X  exchanges  the  note  for  one  of  his  own  payable  at 
the  same  time,  (c)  Jan.  25,  X  takes  up  his  own  note, 
leaving  in  exchange  an  accepted  draft,  due  Feb.  1,  on 
B,  who  is  a  creditor  of  the  partnership,  (d)  Feb.  1, 
.  the  debt  of  the  firm  to  B  becomes  due,  and  B  's  accept- 
ance is  sent  to  him  in  payment. 

Journalize  the  entries. 

(e)  In  the  meantime,  B,  not  knowing  that  X  is  a 
member  of  the  firm  and  that  his  acceptance  will  be 
used  to  cancel  a  debt  to  him,  sends  his  check  to  X 
for  payment  of  the  acceptance.  The  two  letters  cross, 
and  X,  not  knowing  that  the  acceptance  has  been  sent 
to  B,  turns  in  the  check  to  the  cashier,  who  misunder- 
stands X  and  thinks  the  check  is  invested  by  X. 

What  entry  will  the  cashier  make? 

(/)  X  discovers  that  the  cashier  has  misunder- 
stood him,  and  explains.  The  correct  situation  is  dis- 
covered, is  confirmed  by  a  letter  from  B,  and  a  check 
is  sent  to  B,  his  check  being  already  deposited. 

What  entry  shall  now  be  made  to  correct  the 
books? 


QUESTIONS  456 

5.  The  transactions  indicated  below  were  jour- 
nalized as  in  the  entries  below.  Is  the  journalization 
correct  in  each  case?  If  not,  make  a  journalization 
to  correct  the  error,  assuming  that  the  original  jour- 
nalization cannot  be  erased  or  displaced. 

(a)  Sold  gcods,  on  5%  commission,  for  Henry  Esmond,  to  Arthur 
Pendennis,  $1000. 

Arthur  Pendennis       *  $1000 

To  Henry  Esmond  $950 

Commission  50 

(&)  Stationery  bought  and  paid  for  m  returned,  and  the  mon»y  paid 
is  refunded. 

Cash  25 

To  Expense  25 

(c)  We  discount  at  'a  bank  our  own  note  for  $500.  The  discount  is  $7. 
Bills  Keceivable  500 

Interest  7 

To  Cash  507 

(d)  It  is  desired  to  split  up  the  expense  account  into  two  accounts, 
with  stationery  items  kept  by  themselves  in  a  new  account.  The  amount 
of  the  old  items  for  the  new  account  has  been  found,  and  the  transfer  is 
made  on  the  journal. 

Expense  56 

To  Stationery  50 

(e)  While  a  new  building  is  going  up,  the  contractors  receive  advances 
of  money  on  account  of  the  final  payment  on  the  contract.  The  interest 
lost  on  these  advances  is  a  part  of  the  cost  to  the  owners.  They  wish  t« 
enter  it  so. 

Interest  760 

To  Real  Estate  750 


6.  On  which  side  of  the  ledger  is  the  balance  of 
the  following  accounts  likely  to  be?  What,  in  each 
case,  does  the  amount  of  such  a  balance  indicate  ? 

Bills  Receivable.  Merchandise. 

Plant.  Rents. 

Profit  and  Loss.  Commission. 

Wages.  Surplus. 


456  ACCOUNTING  AND  AUDITING 

Chapter  V.    The  Practical  Operations  of  Book- 
keeping.    (Pages  109-138.) 

1.  How  is  it  possible  to  divide  an  entry  between 
two  books  so  that  some  part  is  common  to  both  books, 
and  yet  to  avoid  the  danger  of  double  posting  of  the 
common  part? 

2.  In  posting,  how  much  of  each  entry  should  be 
written  in  the  ledger  ? 

3.  How  are  balances  shown  on  the  cash  book? 

4.  How  are  ledger  balances  shown  ? 

5.  What  is  the  principle  on  which  a  special  book, 
for  example,  the  cash  book,  may  have  several  special 
columns  on  each  side? 

6.  What  are  the  limitations  on  the  use  of  special 
principal  books  and  special  columns? 


Chapter  VI.     Drawing   Conclusions  from  the 
Books.     (Pages  139-173.) 

1.  How  far  does  a  trial  balance  that  shows  equal 
debits  and  credits  prove  that  the  books  are  correct? 

2.  (a)  Show  a  six-column  statement  of  the  fol- 
lowing facts: 

Merchandise  sold,  $43,000;  merchandise  bought, 
$42,000;  merchandise  on  hand,  $13,000;  debts  due  by 
customers,  $15,000;  debts  due  to  creditors,  $12,000; 
proprietor's  investment,  $45,000;  expenses  paid,  $11,- 
000;  expenses  incurred  but  not  yet  paid,  $250;  real 
estate  valuation  (unchanged  during  the  year),  $40,- 
000;  bills  payable,  $9,000;  cash,  $1,000. 

(b)  Show  the  balance  sheet  for  the  new  year. 


QUESTIONS  457 

3.     Pill  out  the  following  incomplete  six-column 
statement,  using  no  figures  not  given  or  implied. 


Dr. 

Cr.    Resources.  Liabilities.    Loss. 

Gain. 

Cash 

20,000 

Office  Furniture 

3,000 

500 

Expense 

13,000 

13,000 

Interest 

500 

50 

Bills  Receivable 

5,000 

Bills  Payable 

2,000 

Accounts  Eeceivable 

3,000 

Accounts  Payable 

1,000 

Merchandise 

20,000 

21,000 

Capital  Stock 

Show  the  balance  sheet  for  the  new  year,  sup- 
posing no  dividends  to  be  declared. 

4.    The  trial  balance  for  the  ledger  shown  below 
fails  to  prove.    Find  the  trouble. 


PEOPEIETOR 

Sundries 

$16,000.00 

Cash 

Bills  Payable 

MERCHANDISE 

$10,549.00           Aaron  Burr 
1,648.00 

1,527.10 

Proprietor 

BILLS   EECEIVABLE 

2,000.00           Aaron  Burr 

1^27.10 

BILLS  PAYABLE 

Merchandise 

1,684.00 

Proprietor 

CASH 

14,000.00           Merchandise 

10,549.00 

Merchandise 

AAEON    BUER 

1,527.10          Bills  Eeceivable 

1,527.10 

458 


ACCOUNTING  AND  AUDITING 


5.    The  figures  below  are  what  a  bookkeeper  finds 
on  his  books  at  the  close  of  the  year : 


Capital  Stock 

$i69,oao 

EeaJ  Estate 

$70,000 

Mortgages  Payable 

55,000 

Bills  Payable 

25,000 

Bills  Eeceivable 

15,000 

Accounts  Eeceivable 

17,000 

Purchases 

150,000 

Cash 

7,000 

Expenses 

15,000 

Interest 

3,000 

Taxes 

2,500 

Sales 

30,500 

$279,500 

$279,500 

He  reports  to  the  directors  a  balance  sheet  as 
follows : 


Eeal  Estate 

$63,000 

Capital  Stock 

$109,000 

Bills  Eeceivable 

15,000 

Mortgages  Payable 

55,000 

Accounts  Eeceivable 

17,000 

Bills  Payable 

25,000 

Merchandise 

130,000 

Eeserve  for  Bad  Debts 

4,250 

Cash 

7,000 

Profit  and  Loss 

21,250 

$253,250 


$253,250 


Explain  all  apparent  discrepancies  between  the 
two  sets  of  figutes. 

6.  Why,  in  a  six-column  statement,  must  the  dif- 
ference between  resources  and  liabilities  equal  the 
difference  between  gains  and  losses  ? 

7.  In  a  proprietor's  absence  the  books  of  a  busi- 
ness are  opened  and  kept  by  a  bookkeeper  who  keeps 
accurate  record  of  transactions  reported  to  him  but 
cannot  be  trusted  to  figure  valuations  or  profits.    At 


QUESTIONS  45& 

the  end  of  a  year,  the  records  show,  before  the  books 
are  closed  and  simply  as  the  result  of  regular  transac- 
tions, the  following  figures : 

Proprietor's  investment,  $100,000;  Bills  Payable, 
$17,000;  Bills  Receivable,  $26,000;  Real  Estate, 
$20,000 ;  Accounts  Payable,  $15,000 ;  Accounts  Receiv- 
able, $20,000 ;  Cash,  $5,000 ;  Merchandise  on  hand,  val- 
ued at  cost,  $75,000;  Merchandise  Dr.  on  ledger, 
$49,500 ;  Expense,  $12,000 ;  Interest  balance  received, 
$500. 

Now  the  proprietor  returns  and  Wishes  to  close 
his  books  for  the  year.  If  he  needs  any  information 
not  given  above,  what  questions  will  he  ask  in  obtain- 
ing it  ?  Assimie  any  fairly  reasonable  answers  to  such 
questions,  if  any,  and  then  show  what  is  the  propri- 
etor's present  investment  in  the  business. 


Chapter  VII.    Some  Highly  Developed  Types  of 
Bookkeeping.     (Pages  175-212.) 

1.  "What  is  a  controlling  account  ? 

2.  What  are  the  advantages  and  the  disadvan- 
tages of  keeping  a  separate  sales  ledger? 

3.  Are  postings  made  to  controlling  accoimts 
from  the  books  of  original  entry,  or  from  the  subordi- 
nate ledgers? 

4.  Why  is  not  error  introduced  when  discounts 
given  are  entered  on  the  receipts  side  of  the  cash 
book? 

/ 


460  ACCOUNTING  AND  AUDITING 

5.  What  is  the  objection  to  ' '  contra  items ' '  in  the 
cash  book? 

6.  Can  books  be  kept  without  a  journal? 

7.  Under  the  so-called  *  impressed"  system  of 
handling  petty  cash,  what  is  represented  by  the  bal- 
ance of  Petty  Cash  in  the  general  ledger? 

8.  Under  the  voucher  system,  what  is  repre- 
sented by  the  credit  balance  of  Vouchers  Payable? 

Chapter  VIII.    The  Peculiarities  of  Corporation 
Accounts.     (Pages  213-237.) 

1.  What  is  the  difference  between  Subscription 
and  Stock  Subscribed? 

2.  Is  it  advantageous  to  distinguish  betw^een 
Stock  Subscribed  and  Capital  Stock? 

3.  What  is  the  proper  entry  for  premium  on  the 
sale  of  stock? 

4.  Does  it  make  any  difference  whether  corpo- 
rators donate  shares  to  a  corporation,  or  take  fewer 
shares  at  a  corresponding  premium? 

5.  Should  each  of  the  following  accounts  show  a 
debit  or  a  credit  balance :  Good  Will,  Subscriptions 
to  Stock,  Dividends,  Surplus?    Why? 

6.  In  combining  proprietorships  into  a  corpora- 
tion, how  is  it  customary  to  allow,  on  the  books,  for 
earning  capacity,  and  to  close  proprietors'  accounts? 

7.  Subscriptions  at  75  are  received  for  treasury 
stock  having  a  par  value  of  $100.  After  the  payment 
of  one  installment  of  the  subscription,  to  the  amount 
of  $25  a  share,  the  subscriber  defaults.  What  entry 
should  be  made  on  the  books  of  the  corporation  at  the 
time  of  forfeiture? 


QUEiiTlOKS  461 

Chapter  IX.    Property  or  Expense? 
(Pages  239-261.) 

1.  Are  nominal  accounts  likely  to  be  worth  face 
value  ? 

2.  Can  all  the  accounts  of  a  business  be  nominal? 

3.  Can  all  the  accounts  of  a  business  be  real  ? 

4.  '^Real  Estate  is  a  capital  account,  and  Rent  is 
a  revenue  account. ' '  How  far  is  this  statement  true  ? 
If  it  is  correct,  what  does  it  mean  ? 

5.  Which  of  the  following  should  be  charged  to 
capital  account  and  which  to  revenue  account:  the 
purchase  of  a  patent  right ;  legal  fees  for  organizing 
a  corporation;  the  purchase  of  a  lease;  repairs  of 
machinery ;  replacement  of  machinery ;  the  purchase 
of  additional  machinery ;  the  loss  by  fire  of  uninsured 
property  ? 

6.  In  a  manufacturing  business  what  accounts 
should  you  open  and  charge  for  the  following  expen- 
ditures ?  Should  each  of  such  accounts  be  treated  at 
the  end  of  the  year  as  a  capital  account  or  as  a  rev- 
enue account? 

Taxes  on  a  piece  of  real  estate  held  for  possible 
extension  of  plant. 

Wages  of  a  chemist  carrying  on  experiments  for 
improvement  of  processes. 

Contributions  to  an  agency  for  gathering  infor- 
mation about  foreign  markets. 

Expense  of  maintaining  an  exhibit  at  an  interna- 
tional exposition. 

Compensation  to  the  owner  of  a  piece  of  land 
when  a  lease  on  that  land  is  by  mutual  agreement 
canceled. 


i62  ACCOUNTING  AND  AUDITING 

7.  What  is  the  test  for  determining  the  things 
that  should  be  charged  (1)  to  capital?  (2)  to 
revenue  ? 

Is  there  any  middle  ground  in  which  a  charge 
may  be  made  def  ensibly  to  either  capital  or  revenue  ? 
If  so,  what  defence  is  commonly  offered  for  charging 
to  each? 

8.  A  new  machine  costing  $5,000  is  bought  to 
replace  one  that  originally  cost  $5,000,  but  is  now 
worn  out.  The  expense  of  operating  the  new  machine 
will  be  only  three-fourths  that  for  the  old.  How 
much  shall  be  charged  to  Maintenance  at  the  time  of 
replacement? 

9.  The  new  machine  mentioned  in  question  8, 
above,  is  now  supposed  to  cost  $7,000.  The  expense 
of  operation  will  be  the  same  as  for  the  machine 
now  worn  out.  How  much  shall  be  charged  to 
Maintenance  ? 


Chapter  X.    Depreciation.     (Pages  263-280.) 

1.  What  is  the  argument  for  figuring  deprecia- 
tion of  machinery  at  a  decreasing  rate  ? 

2.  Suppose  a  piece  of  property  has  depreciated 
in  value  to  the  amount  of  $1,000.  Then  $3,000  is  spent 
on  it,  making  it  so  much  better  than  it  was  originally 
that  its  earnings  will  be  $200  more  than  originally. 
How  shall  that  $3,000  be  charged? 

3.  What  is  usually  credited  when  Maintenance 
is  charged'? 

4.  What  is  usually  credited  when  Depreciation  is 
charged? 


QUESTIONS  463 

5.  Should  Maintenance  go  upon  the  income  sheet 
or  upon  the  balance  sheet? 

6.  Should  Depreciation  go  upon  the  income  sheet 
or  upon  the  balance  sheet  ? 

7.  Which  sheet  is  affected  by  the  credit  madq 
when  Depreciation  is  debited? 

8.  On  Dec.  28, 1910,  you  buy  a  patent  right  under 
which  you  can  manufacture  and  sell  annually  for 
five  years  in  one  state  1,000  desk  attachments  at  a 
profit  of  one  dollar  each  over  the  profit  on  the  only 
unpatented  marketable  Article. 

(a)  From  the  table  below,  determine  as  accurately 
as  you  can  the  theoretical  value  of  that  patent  right 
when  money  is  worth  5%. 

Present  worth  of  $1  due  in  6  years,  at  5% $0,746215 

Present  worth  of  $1  due  in  5  years,  at  5% 0.783526 

Present  worth  of  $1  due  in  4  years  at  5% 0.822702 

Present  worth  of  $1  due  in  3  years  at  5% 0.863838 

Present  worth  of  $1  due  in  2  years  at  5% 0.907029 

Present  worth  of  $1  due  in  1  year,    at  5% 0.952381 

(6)  Is  your  figure  absolutely  accurate  for  the  the- 
oretical value,  or  is  it  based  on  a  calculable  error  ?  If 
the  latter,  how  should  you  calculate  the  error  ? 

(c)  Shall  that  patent  right  appear  on  a  balance 
sheet  for  Dec.  31,  1911,  on  an  income  sheet  for  1911, 
on  both,  or  on  neither  ?  If  so,  for  what  approximate 
amount  ? 


Chaptek  XI.    Profits.     (Pages  281-304.) 

1.    What  ought  books  to  show  with  regard  to  dis- 
counts (on  merchandise)  for  prompt  payments  f 


464  ACCOUNTING  AND  AUDITING 

2.  You  are  charged  with  ^^  taking  account  oi 
stock"  in  a  store.  The  clerks  give  you  the  numbers 
and  descriptions  of  articles,  and  the  invoice  book- 
keeper fills  in  prices  as  they  appear  on  incoming  bills. 
How  far  is  this  material  adequate  for  an  inventory? 

3.  In  what  sense  is  discount  on  bonds  issued  an 
asset  ? 

4.  Is  it  true  that  premium  on  bonds  bought  is 
an  asset? 

5.  Is  it  true  that  premium  on  stock  sold  is  profit  ? 

6.  How  should  you  treat  interest  received  on  a 
bond  bought  above  par  ? 

7.  Except  for  the  items  mentioned  below,  a  cor- 
poration's balance  sheets  for  1909  and  1910  show  the 
same  figures.  How  much  do  these  items  tell  about  the 
history  of  the  corporation  for  the  year  1909-1910  ? 


1 

1909 

Surplus 

$70,000 

1910 

liation  Fund 

$20,000 

General  Reserve 

60,000 

Depreciation  Reserve 

20,000 

Surplus 

10,000 

8.  If  in  the  case  indicated  in  question  9  for  Chap- 
ter 9  the  whole  $7,000  was  charged  to  Maintenance, 
would  you  call  the  $2,000  excess  cost  of  the  new  ma- 
chine over  the  old  a  secret  reserve  ? 

Chapter  XII.    The  Income  Sheet. 
(Pages  305-314.) 

1.  What  is  the  relation  between  an  income  sheet 
and  a  balance  sheet?  Can  an  item  appear  upon  both 
at  the  same  time  ? 


QUESTIONS  465 

2.  The  following  is  a  condensed  trial  balance 
of  a  partnership.  The  only  inventory  is  for  sup- 
plies, which  amounts  to  $25,000.  No  accrued  or  pre- 
paid items  are  outstanding.  Allow  10%  depreciation 
on  all  accounts  (except  cash  and  supplies)  represent- 
ing property,  5%  on  all  sums  due  the  business  from 
outside,  credit  the  partners  5%  interest  on  their 
investments,  credit  salaries  to  the  partners  at  $3,000 
for  A  and  $2,000  for  B,  and  then  divide  profit  or 
loss  equally  between  the  partners.  Show  the  income 
sheet. 


A 

$40,000 

B 

20,000 

Plant  and  Machinery 

$45,000 

Supplies 

43,000 

Sales 

95,000 

Labor 

30,000 

Expense 

7,500 

Interest 

600 

Discounts 

1,250 

Fuel 

3,000 

Insurance 

1,150 

Freight 

1,500 

Accounts  Payable 

9,000 

Accounts  Receivable 

32,000 

Steam  Earnings 

1,500 

Cash 

500 

$165,500 

$165,500 

3.    A  profit  and  loss  account  at  the  end  of  a  year, 
after  the  books  have  been  closed  is  as  shown  below. 


A  &  A-30 


466 


AccouNTma  AitTt)  AtrmTma 


Present  in  the  most  intelligible  form  the  information 
that  it  gives  about  the  business  for  the  year. 


Peofit 

AND    Loss 

Fife.    l,BiU8  Rm. 

$200 

Jan.    : 

Dfc.  81,  Bad  Debt! 

700 

Dec.  3: 

Neglected  Discounts        50 

Expense 

400 

Wagee 

28,000 

Deprcclatioa 

T,009 

Diridend,  No.  07 

8,500 

Dividend,  No.  68 

3,500 

Bmlano6 

16^00 

$50,859 

1,  Balance  $15,000 

1,  Interest  400 

Rent  1,200 

Collected  Discount  300 

Trading  Account  42,950 


$59,850 


Chapter  XIII.    The  Balance  Sheet. 
(Pages  315-330.) 

1.  If  payments  are  received  on  account  of  goods 
in  process  of  manufacture,  should  such  payments 
appear  on  the  balance  sheet  ?    If  so,  where  ? 

2.  Is  it  worth  while  to  open  a  Bills  Discounted 
account  in  the  ledger  ?  When  would  such  an  account 
be  debited  and  when  credited? 

3.  Why  is  it  desirable  to  divide  balance-sheet 
items  into  groups? 

4.  Certain  items  on  the  liabilities  side  of  a  cor- 
poration balance  sheet  appeared  on  December  31  in 
different  vears  as  follows : 


1907 

1908 

1909 

Allowance  for  bad  debts 

$50,000 

$100,000 

Reserve  for  depreciation 

$50,000 

100,000 

200,000 

Reserve  for  betterments 

150,000 

200,000 

Surplus 

450,000 

400,000 

500,000 

.QUESTIONS 


467 


The  income  sheet  for  1908  showed  surplus  for  the 
year  $150,000;  and  that  for  1909  showed  $250,000. 

Are  the  income-sheet  figures  consistent  with  the 
balance-sheet  figures?  If  not,  why?  If  so,  what 
journal  entries  for  each  year  produced  the  changes  in 
the  balance  sheets  above? 


Chapter  XIV.    The  Interpretation  of  Balance 
Sheets.     (Pages  331-346.) 

1.    The  balance  sheet  of  a  corporation  on  Decem- 
ber 31,  1908,  stood  as  follows: 


Real  Estate 

$50,000 

Capital  Stock 

$200,000 

Plant 

95,000 

Accounts  Payable 

20,000 

Horses,  etc. 

15,000 

Bills  Payable 

25,000 

Patents 

20,000 

Profit  and  Loss 

15,000 

Merchandise 

30,000 

Accounts  Receivable 

30,000 

Cash 

20,000 

260,0©0 


260,000 


On  December  31,  1909,  the  books  appeared  as 
below: 


Real  Estate 

$55,000 

Capital  Stock 

$200,000 

Plant 

88,000 

Accounts  Payable 

12,000 

Horses,  etc. 

12,000 

Bills  Payable 

17,000 

Patents 

19,000 

Profit  and  Loss 

*       33,000 

Merchandise 

42,000 

Accounts  Receivable 

28,00!) 

Cash 

18,000 

^ 

262,000 


262,0«0. 


What  were  the  profits  for  the  year  ? 
Where  are  they? 


468  ACCOUNTING  AND  AUDITING 

2.  You  organize  a  corporation,  and  on  January 
1,  1908,  the  following  facts  are  shown  by  the  books : 

The  corporation  has  taken  over  from  an  indi- 
vidual owner  a  business  of  which  the  assets,  deter- 
mined by  conservative  valuation  of  the  property,  are 
$100,000  (Bills  Receivable  and  Accounts  ReceivaWe, 
$20,000;  Supplies,  $5,000;  Real  Estate  and  Plant, 
$75,000).  Capital  stock  to  the  amount  of  $500,000 
has  been  issued,  of  which  $200,000  has  been  given  the 
original  owner  for  his  title,  and  $300,000  has  been 
sold  for  cash  at  par.  The  corporation  has  bought  a 
neighboring  plant  for  $100,000,  paying  for  it  by  BiUs 
Payable  to  that  amount. 

Show  a  brief  balance  sheet  under  these  conditions. 

Now,  you  are  absent  from  the  corporation's  affairs 
for  two  years.  On  your  return  you  are  told  that 
6  per  cent,  dividend  has  been  paid  in  each  year,  and 
you  are  shown  the  balance  sheets  below. 

Give  a  brief  history  of  the  business  for  each  of 
the  two  years  of  your  absence. 


Jan.  ] 

L,  1909. 

Eeal  Estate  and  Plant 

$420,000 

Capital  Stock 

$500,000 

Bills  Rec.  and  Accts.  Eec. 

70,000 

Funded  Debt 

100,000 

Supplies 

5,000 

Profit  and  Loss 

20,000 

Merchandise 

105,000 

Cash 

20,000 

$620,000 

$620,000 

' 

Jan.  1 

.,  1910. 

Eeal  Estate  and  Plant 

$400,000 

Capital  Stock 

$600,000 

Depreciation  Fund  Bonds 

20,000 

Eeserve  Fund 

20,000 

Eeserve  Fund  Bonds 

20,000 

Profit  and  Loss 

20,000 

Bills  Eec.  and  Accts.  Eec. 

70,000 

Supplies 

5,000 

Mixchandis© 

105,000 

Cash 

20,000 

$640,000  $640,000 


QUESTIONS  469 

3.    The  balance  sheet  of  a  corporation  on  Jan.  1, 
1909,  was  as  follows: 


Merchandise 

$65,000 

Capital  Stock 

$75,000 

Bills  Eeceivable 

15,000 

Bills  Payable 

10,000 

Accounts  Eeceivable 

8,000 

Accounts  Payable 

5,000 

Fixtures 

3,000 

Surplus 

5,000 

Cash 

4,000 

$95,000  $95,000 

During  the  year  1909,  the  net  income  was  $10,000 ; 
purchases,  $200,000;  sales,  at  20%  above  cost  price, 
$240,000;  cash  decrease,  $3,000;  bills  receivable 
accepted,  $5,000  in  excess  of  such  notes  collected; 
accounts  receivable  charged,  $1,000  in  excess  of 
accounts  receivable  collected;  bills  payable  extin- 
guished, $1,000  in  excess  of  those  issued;  accounts 
payable  incurred,  $2,000  in  excess  of  those  paid ;  divi- 
dends paid,  $8,000. 

Show  the  balance  sheet  for  January  1,  1910. 

4.  You  contemplate  purchasing  an  interest  in  a 
business  that  has  run  five  years,  and  agree  to  pay  one- 
third  the  valuation  of  its  net  assets.  The  following 
statement  is  given  you  by  the  partners : 


Dr. 

Buildings,  machinery,  etc.,  at  Cost 

$50,000 

Expended  for  repairs  and  renewals 

8,000 

Patent  rights  purchased 

14,000 

Balance  of  sales  ledger 

26,000 

Inventory,  as  per  stores  and  .^tock  books 

19,000 

$117,000 

Cb. 

Bilk  payable 

$48,000 

Baliinec  of  purchase  ledger 

47fiOQ 

PavtaifiPB'  capital 

22,000 

$117,000 


470  ACCOUNTING  AND  AUDITING 

(a)  Assuming  that  this  statement  gives  all  that 
you  need  to  know,  how  much  must  you  pay  for  your 
interest  in  the  business  ? 

(6)  Does  this  statement  give  all  necessary  infor- 
mation about  the  assets?    If  not,  what  is  lacking? 

5.  Comment  upon  the  condition  of  a  corporation 
which  shows  the  following  amounts  for  1910  com- 
pared with  1909 : 


Accounts  Eeceivable 

Bills  Receivable 

Accounts  Payable 

Bills  Payable 

Merchandise  inventory 

Gash 

Sales 

Purchases 

Surplus 


Chapter  XV.    The  Determination  ^of  Costs. 
(Pages  347-373.) 

1.  What  is  the  common  mechanism  for  showing 
the  prime  cost  of  labor? 

2.  What  is  shown  by  the  stores  ledger? 

3.  What  are  the  ultimate  purposes  to  be  served 
by  cost  accounting? 

4.  What  are  the  chief  elements  in  a  machine 
rate? 

5.  Why  is  idle  machine  time  of  consequence? 

6.  Should  burden,  or  overhead  cost,  be  an  impor- 
tant factor  in  the  accounting  of  retail  department 
stores ;  of  wholesale  department  stores ;  of  charitable 
institutions;  of  railroads? 


1909 

1910 

$55,000 

$66,000 

20,000 

25,000 

20,000 

23,000 

15,000 

16,500 

30,000 

37,500 

8,000 

8,500 

300,000 

310,000 

225,000 

238,000 

10,000 

29,500 

'  QUESTIONS  471 

7.  On  what  basis  should  you  distribute  general  or 
overhead  expenses  to  manufacturing  orders  under 
the  following  conditions: 

(a)  In  a  shop  making  hand  product  only  and 
employing  workmen  of  low  grade  only? 

(6)  In  a  shop  making  hand  product  only,  employ- 
ing some  low-grade  and  some  high-grade  labor,  and 
seasoning  one-fourth  of  its  product  through  the  vari- 
ous steps  of  manufacture  so  that  one  year  is  required 
for  completion  of  the  various  processes  for  that  part, 
but  the  other  three-fourths  of  the  product  is  com- 
pleted in  one  month  ? 

(c)  In  a  shop  making  part  of  its  product  by  hand, 
part  by  low-cost  machines,  part  by  high-cost 
machines,  employing  both  high-grade  and  low-grade 
labor,  and  turning  out  all  product  rapidly? 

Chapter  XVI.    Settlements  Based  on  Accounts. 
(Pages  375-395.) 

1.  Under  what  conditions  is  goodwill  creditable 
to  partners?    Why  not  otherwise? 

2.  How  does  a  statement  of  affairs  for  an  insol- 
vent business  differ  in  form  and  arrangement  from  a 
balance  sheet?  Construct  an  imaginary  balance 
sheet  that  will  do  for  illustration,  and  then  make  out 
a  possible  statement  of  affairs  to  correspond. 

3.  What  is  a  Realization  and  Liquidation 
account? 

4.  Is  Deficiency  the  same  as  a  debit  balance  to 
Profit  and  Loss? 

5.  In  a  corporation,  is  Deficiency  the  same  as 
Deficit? 


472  ACCOUNTING  AND  AUDITING 

6.  Below  is  a  summary  of  single-entry  partner- 
ship books,  with  the  inventories. 

Set  aside  five  per  cent  on  the  value  of  all  assets 
(except  cash)  as  a  reserve  fund  for  depreciation 
and  for  accrued  items  not  on  the  books,  and  divide 
profits  equally  between  the  partners.  Show  the  bal- 
ance sheet  after  the  books  are  closed. 

James  Otis,  Inveetment  $43,750 

Henrj  Vane,  Investment  50,000 

Withdrawals  by  Partners  ($2,000  each)  4,000 

Inventory,  Goods  65,925 

Inventory,  Bills  Receivable  38,400 

Inventory,  Furniture  and  Fixtures  4,750 

Cash  on  Hand  14,065 

Caah  Paid  for  Wages  22,500 

Cash  Paid  for  General  Expenses  14,170 

Cash  Paid  for  Raw  Material                         '  16,250 

Sums  Owed  for  Raw  Material  6,250 

Bills  Payable  37,500 

Debits  to  Customers  81,ft90 

Credits  to  Customers  59,190 

7.  Construct  a  Deficiency  Account  to  fit  the  situ- 
ation disclosed  by  the  following  condensed  trial  bal- 
ance and  the  subsequent  entries  shown. 


Capital  Stock 

$65,000 

Real  Estate 

$210,000 

Merchandise 

80,000 

Bills  Receivable  and  Accounts  Receivable    43,500 

Bills  Payable  and  Accounts  Payable 

304,500 

Expense 

30,670 

Bills  Receivable'  Discounted 

25,000 

Cash 

30,330 

$394,500 

$394,500 

Bills  Discounted 

$25,000 

To  Cash 

$25,000 

Protested  endorsed  notes  taken  up^ 

QUESTIONS  473 

Bad  Debts  17,000 

To  Accounts  Receivable  17,000 

Bad  accounts  closed 

Profit  and  Loss  24,000 

To  Merchandise  24,000 

Depreciation  on  old  stock,  30% 

Maintenance  of  Real  Estate  5,000 

To  Cash  5,000 

Repairs  on  property 


8.  A  partnership  agreement  provides  for  equal 
division  of  profits.  The  following  trial  balance  is 
normal  for  the  business  concerned.  What  light  does 
it  cast  upon  the  adequacy  of  the  partnership 
agreement  ? 


A 
B 
C 

$1,000 

7,000 
15,000 

$50,627 
27,510 
42,568 

Bills  Payable 
Accounts  Payable 
Real  Estate 

62,000 

30,000 
23,000 

Merchandise 

60,705 

Bills  Receivable 

15,000 

Accounts  Receivable 

17,000 

Sales 

Purchases 

175,000 

210,000 

Expense                                     i 
Interest 

27,000 
1,500 

Neglected  Discount 

2,500 

$a88,705 

$383,705 

Chapter  XVII.    Auditing.     (Pages  397-449.) 

1.  If  an  auditor  knows  that  no  dishonesty  has 
been  practiced,  may  he  confine  his  work  to  checking 
the  bookkeeping,  begimikig  with  the  books  of  original 
entry  *? 


474  ACCOUNTING  AND  AUDITING^ 

2.  Is  a  signed  acknowledgment  from  an  officer 
of  a  corporation  sufficient  voucher  for  items  which 
otherwise  an  auditor  would  personally  examine? 

3.  What  is  the  function  of  an  auditor's  note 
book? 

4.  "What  are  the  more  common  methods  of  hiding 
the  extraction  of  cash  from  customers'  remittances, 
and  how  does  an  auditor  detect  resort  to  them  ? 

5.  Why  is  not  the  controlling  account  a  sufficient 
check  on  sales  accounts  ? 

6.  What  are  the  more  common  methods  of  over- 
stating cash  payments,  and  how  does  an  auditor  detect 
resort  to  them? 

7.  How  should  you  audit  payments  of  interest ; 
of  taxes ;  of  notes  payable ;  of  discounted  notes  pro- 
tested; of  officers'  salaries;  of  dividends? 

8.  Why  does  an  audit  usually  begin  with  cash? 

9.  Why  do  journal  items  require  special  care? 

10.  What  precautions  should  be  taken  against 
padded  inventories? 

11.  In  examinations,  how  far  may  certificates 
take  the  place  of  auditing? 

12.  What  is  the  function  of  an  auditor's  report? 


INDEX 


Account,   defined,  34 

Account  sales,   193 

Accounts  Payable,   119,  345 

Accounts  Receivable,  119,  344 

Accounting     compared     with     book- 
keeping, 13 

Accrued  items,  157,  282,  319 

Additional  rate,  365,  371 

Allowance  for  Bad  Debts,  326 

Assets,  classes  of,  316 

Auditing,   397-449 

(To  avoid  confusion  with  the  gen- 
eral index,  a  special  index  for 
the  chapter  on  auditing  is 
given  at  the  end.) 

Auxiliary  books,  118 


B 


Bad  debts,  103,  324,  330 
Balance  sheets,  described,  173,  260, 
315 

illustrated,  261,  330 

comparison  of,  330,  331 

interpretation  of,  343 
Balancing,  method  of,  115 
Bill  book,  118 

Bills  Discounted  account,  320,  330 
Bills  Payable    account,   use    of,    58, 

78,  93 
Bills  Receivable  account,  52,  92,  344 
Bonds,  discoumt  on,  reason  for,  27«, 
294 

premium  on,  250,  274,  2»3 
Book  account,  79 


Bookkeeping  compared  with  account- 
ing, 13 
Burden,  see  Cost,  overhead 


Capital  stock,  aceount,  213 

sold  at  a  premium,  223,  233,  294 

sold  at  a  discount,  224,  229,  235, 
295 
Cash  account,  use  of,  51,  92 
Cash  book,  use  of,  36 

form  of,  41,  122,  123 

special-column,  131,  178,  180,  192 
Cash-sales  book,  111 
Charging  against  revenue,  259 
Charging  to  capital,  259 
Checking,  in  posting,  110 

blank.  111,  116,  132 
Collected  Discounts  account,  286,  346 
Contingent  items,  319 
Commercial  discounts,  see  Merchan- 
dise Discount  account 
Commission  cash  book,  irregular,  192 
Consignments  account,  193 
Contra  entries,  114,  178 
Contracts,  profit  on,  290 
Controlling  account,  defined,  176 
Corpus  of  estate,  385 
Cost,  prime,  348,  351 

overhead,  348,  352 

joint,  349 

apace,  355,  370 

selling,  368 
Cost   accounting,   purposes   of,  348, 
350 


475 


\ 


476 


INDEX 


Cost  book,  352 

Credit,  meaning  of,  21,  32 

Creditors  account,  see  Accounts 
Payable 

Customers  account,  see  Accounts  Re- 
ceivable 

Customers  ledger,  see  Sales  Ledger 


Day  book,  35 
Debit,  meaning  of,  21,  32 
Deficiency  account,  393,  394,  395 
Deficit,  304,  307,  323,  330 
Depreciation,    on    six-column    state- 
ment, 157 
prevented  by  maintenance,  267 
methods  of  calculating,  268 
methods  of  entering,  279 
nature  of,  295 
Depreciation  fund,  ,279,  298 
Details,  fullness  of,  44 
Discount,  entered  contra,  114,  179 
(see    also    Interest,    Interest    ac- 
count.   Merchandise    Discount 
account,    Neglected    Discount 
account.     Collected     Discount 
account.  Bonds,  Capital  Stock) 
Dividends,  on  income  sheets,  305 
Dividends  account,  213 
Donated  stock,  228 
Double  entry,  origin  of,  31 

in  showing  profits,  151 
Drafts  as  bills  receivable,  53 


as  bills  payable,  59 


E 


Earnings,  gross,  310 

net,  310 
Earnings  account,  302 
Erasures,  45 
Errors,  correction  of,  45 

detection  of,  142 
Expense  aoeount,  60 
Explanation   accounts,   28 

(see  also  Nominal  aceoimts) 


F 


Fashion  affecting  values,  264,  265 
Fixed  charges,  312 
Force  accounts,  26 

(see  also  Nominal  accounts) 
Foreign  currencies,  bookkeeping  for, 

211 
Furniture  and  Fixtures  account,  59 


Good  will,  221,  381 
Gross  earnings,  310 


Idle  time,  362,  370 

Impressed  system  of  petty  cash,  202 

Income,  "  other,  *'  812 

net,  312 
Income   account,   use   of,    173,    302, 

306 
Income  sheet,  use  of,  173,  260,  305 

illustrated,  261,  308,  309,  313 
Insolvency,  386 
Installment     Subscription     account, 

215 
Interest,   as  affecting   the  value  of 

notes,  55 
on  income  sheets,  312 
Interest  aecount,  use  of,  61,  66,  81, 

82 
Inventories   in   figuring   profits,   95, 

258,  263,  372 
Inventory  account,  97 
Invoice  book,  see  Purchase  bo«k 


Journal,  use  of,  35 

forms  of  entry,  36,  38,  121 

footing  of,  lis 

special  forms  of,  185,  IflT,  IW 

elimination  of,  191 
JournaJteatioB,  parpos«  of,  35 


INDEX 


m 


Labor-eaviug,  principle  of,  37 
Ledger,  use  of,  33 

legal  status  of,  48 

manner  of  posting  to,  110,  126 

closing  accounts  in,  163,  167 

subordinate,  175,  192 

sales,  176 

cuitomers,  176 

purchase,  177 

tabular,  204 

stock,  214,  220 

stockholders,  214,  220 

installment,  217 

stores,  351 

machine,  367 
Ledger  folio  column,  use  of,  110 
Leases,  277 

Liabilities,  classes  of,  316 
Loss,  extraordinary,  302,  307 
(see  also  Profit  and  loss) 


M 


Machine  rate,  358 

Machinery  and  plant  account,  59 

Maintenance  account,  242,  266,  279 

excessive  charges  to,  299 
Manufacturing  and  Selling  Account, 

306 
Manufacturing  account,  370 
Manufacturing  accounts,  347 
Merchandise,  valuation  of,  259,  263, 

284,  289,  344 
Merchandise  account,  use  of,  64,  94 
Merchandise    Discount    account,    use 

of,  102,  286,  346 
entry  of,  113,  183 
Minimum  rate,  365,  370 


Net  income,  see  Income 

Nominal  accounts,  28,  30,  61,  94,  240, 

249,  259 
closing,  -164 
Notes,    see    Bills    Receivable,    Bills 

Payable,  Bills  Discounted 


Obsolescence,  253,  266 
Occupied  time,  365 
Operating  Account,  306 
Operating  expense,  310 
Operating  ratio,  310 
Original  entry,  books  of,  47 


Partnership,  375 
Personal  accounts,  30 
Petty  Accounts,  204 
Petty  Cash,  use  of,  202 
Posting,  defined,  35 

method  of,  110,  117 
Posting  checks,  110 
Premium,    see    Bonds,    and    Capital 

Stock 
Prepaid  items,  278 
Principal  books,  117 
Private  ledger,  208 
Profit,    determining,    150,    281,    325, 
326 

as  between  years,  283,  307 

extraordinary,  301,  302,  307 
Profit  and  Loss  account,  use  of,  lOt, 

306,  307 
Property  accounts,  24,  93 
Purchases  account,  97 
Purchase  book,  use  of,  36 

form  of,  42,  124 


N 


B 


Neglected    Discounts    account, 

346 
Net  earnings,  310 


286,      Rates,  machine,  358 
minimum,  365,  370 
additional,  365,  371 


An 


INDEX 


Eeal  accouats,  80,  240,  249,  259 

Be«l  estate  account,  59 

Eealizatioa  and  Liquidation  account, 

390,  393 
Red  ink  item*,  115,  156,  163 
Beplacements,  246,  266,  299 
Beserye  accounts,  use  of,  106,  268, 

325,  326 
Beierve  secret,  299 
Responsibilitj,  basis  of  aecounting, 

21 
Seturned  purchases,  9S 
Returned  sales,  98 
Royalty  contracts,  277 


Bales  account,  98 
Sales  book,  use  of,  36 

form  of,  43,  125 
Sales  ledger,  described,  176 
Secret  reserve,  299 
Selling  cost,  368 
Shipments  account,  193 
Short  extension,  182 
Single  entry,  31,  382 
Sinking  fund  as  surplus,  300 
Sinking  fund  method,  268 
Six-column  statement,  described,  152 

illustrated,  154 
Space  cost,  355 

Solvency,  method  of  showing,  315 
Special    column,    principle    of,    128, 

182 
Special-column  cash  book,  131,  178, 

180,  192 
Special-column  journal,  135,  137,  138 
Statement  of  affairs,  386 
Statement  of  resources  and  liabili- 
ties, 324,  327 
Stock  account,  372 
Stock  Subscribed  account,  215 
Stores  account,  351 
Stores  ledger,  351 
Subordinate  ledgers,  175,  192 


Subtractions,     how     performed     in 

bookkeeping,  115 
Supplies,  on  a  balance  sheet,  318 
Surplus,  account,  use   of,   106,   223, 
297,  307,  314,  317,  322 

capital,  224,  230,  294 

donated,  228 

premium,  294 

sinking  fund  as,  300 

for  year,  313 
Suspense  account,  104,  105 


T 


Tabular  ledger,  204 
Taxes,  on  income  sheets,  309,  311 
Trading  Account,  306,  372 
Treasury  stock,  228,  231 
Treasury  Stock  Subscribed,  236 
Trial  balance,  defined,  139 

illustrated,  141 

errors  disclosed  by,  142 

importance  of,  145 

inadequacy  of,  146 

getting  a  stubborn,  147 
Trusteeships,  384 
Truth,    as    the    aim    of    accounting, 

283,  300 
Turnover,  444 


Valuation,  bases  for,  240 

on  cost  of  duplication,  243,  244 

on  earning  capacity,  244 

on  cost,  245 

for  inventories,  258,  263 

of  claims,  324,  345 

of  reserves,  327 
Vouchers  Payable,  206 
Voucher  register,  206 
Voucher  system,  205 

W 


Wasting  assets,  254 


INDSX 


479 


AUDITING 


Auditing,  soop*  of,  400 

firfit  steps  in,  402 
Auditor,  private  mark  of,  438 

responsibilitieB  of,  445 

qualifications  of,  448 
Assets,  checking,  404 
Bad  debts,  406,  427,  435 
Balance  sheet,  434,  440 
Bills  Discounted,  409,  426^  435 
BUls  Payable,  408,  423,  426 
Bills  Eeceivable,  409,  435 
Bonds,  423,  435,  438,  441 
Branch  accounts,  436 
Capital  stock,  436,  437,  438 
Cash  account,  fraud  in,  405,  467, 
422 

checking,  415 
Cash  items,  426 
Check  book,  415,  418,  430,  422 
Cheeking,  409,  412,  413,  416,  423, 

425,  426,  429,  431 
Checks,  outstanding,  422 
Confirming,   411,   428,   429 
Controlling     accounts,     412,    414, 

432 
Corrections,  484 

Creditors'  accounts  confirmed,  432 
Cross  footing,  412,  429 
Customers '     accounts,     confirmed, 

432 
examined,  442 
Deposits,  421,  425 
Discounts,  406,  407,  417,  424,  425, 

426,  435 
Distribution,  412,  429 
Dividends,  423,  437 


Examinations,  distinguished  from 
audits,  397 

conduct  of,  440-444 

Inactive  accounts,  408 

Income  sheet,  438,  440 

Insurance,  407 

Interest,  407,  423,  425,  437 

Inventories,  409,  430 

Journal,  426 

Ledgers,  checking,  412,  413,   414 

Minutes  of  directors,  423,  437 

Mortgages,  423,  425,  438 

Note  book,  auditor  \  402,  403, 
404,  413,  419,  424,  426,  428 

Pass  book,  415,  418,  420,  421,  422 

Petty  cash,  424 

Real  Estate,  423 

Reconcilement,  416,  418,  420 

Rents,  423,  425 

Report,  400,  413,  424,  428,  439, 
441-444 

Returns,  406,  407,  425,  429,  431 

Salaries,  423 

Salting,  443 

Securities,  423,  436 

Statements  substituted  for  audit- 
ing, 400,  414,  428,  430,  436, 
437 

Stocks,  423 

Taxes,  407 

Tracing,  415,  428,  431 

Trial  balances,  403,  414,  432 

Verifying,  411,  425 

Vouching,  411 

Wages,  424 


re  2520< 


^^j#  *  '^^  V 


